S Corporations offer significant tax advantages for closely held businesses, but they also come with strict requirements. One of the most important rules is that only certain individuals and entities may be shareholders. A nonresident alien cannot own stock in an S Corporation under any circumstances.

This restriction can create complications when a nonresident alien provides funds to the corporation. If the IRS suspects that the funds are not a true loan but instead resemble an equity investment, the corporation may face the loss of its S Corporation status. Fortunately, the Internal Revenue Code offers a safe harbor for debt instruments that meet specific criteria.

If a nonresident alien loans money to an S Corporation, and the terms of the loan resemble stock ownership, such as repayment tied to profits or the ability to convert the loan into equity, the IRS may treat the arrangement as a disguised sale of stock. This can lead to an immediate termination of S Corporation status and the imposition of C Corporation tax treatment.

To prevent this from happening, the Internal Revenue Code provides a safe harbor for what it calls “straight debt.” If the debt meets the safe harbor requirements, it will not be treated as a second class of stock or an impermissible ownership interest. The conditions are as follows:

1. The obligation must be in writing
2. It must be an unconditional promise to pay a sum certain in money either on demand or on a specified date
3. The interest rate and the interest payment dates must not be contingent on profits, the borrower’s discretion, or similar factors
4. The debt must not be convertible into stock, either directly or indirectly
5. The creditor must be one of the following:
   •A person eligible to be an S Corporation shareholder under Subchapter S
   • A lender that is actively and regularly engaged in the business of lending money, such as a bank

If the loan meets all of these requirements, the IRS will not recharacterize it as equity, even if the lender is a nonresident alien.

Business owners often seek funding from friends, family members, or investors. In some cases, those individuals live outside the United States and are not eligible S Corporation shareholders. If those funds are not properly documented or if the loan terms are drafted loosely, the IRS may treat the transaction as an impermissible ownership interest.

For example, if a foreign investor loans $100,000 to an S Corporation but repayment is tied to the company’s success or profitability, the IRS may argue that the investor holds an indirect equity interest. This could invalidate the company’s S election.

At Twisdale Law, PC, we assist business owners throughout North Carolina, South Carolina, and Tennessee in preserving their S Corporation status while securing outside financing. Our team can:

• Review existing loan agreements for compliance with the safe harbor rules
  • Draft promissory notes that meet the requirements of Section 1361(c)(5)
  • Provide strategic guidance when working with international lenders or family members abroad
  • Advise on shareholder agreements and financing structures that reduce risk

If you are considering borrowing funds from a nonresident individual or outside party, legal review is essential.

To protect your S Corporation status and avoid IRS recharacterization, contact Twisdale Law, PC. We can help ensure that your financing arrangements are structured properly and in full compliance with the Internal Revenue Code.