Director's Loan Agreement

A Director's Loan Agreement in the United States governs a credit facility, defining the lender's and borrower's rights over the life of the loan.

Director loans are a frequent occurrence in closely held corporations and owner-managed businesses, where the line between the director's personal finances and the corporate treasury can blur. Common scenarios include a director withdrawing funds for personal use in anticipation of a future dividend, a director advancing personal funds to the company during a cash flow shortfall, or a company providing a relocation loan or housing assistance to a key director.

The federal tax treatment of director loans is governed primarily by IRC Section 7872, which addresses below-market loans. When a corporation makes a loan to a director at an interest rate below the Applicable Federal Rate (AFR), the IRS imputes interest income to the corporation and treats the foregone interest as a constructive distribution to the director. If the director is a shareholder, the constructive distribution is treated as a dividend to the extent of the corporation's earnings and profits. The AFR is published monthly by the IRS in Revenue Rulings and varies based on the loan term: short-term (loans of three years or less), mid-term (over three years but not over nine years), and long-term (over nine years).

For publicly traded companies, the Sarbanes-Oxley Act of 2002 (SOX) imposes additional restrictions. Section 402 of SOX (15 U.S.C. Section 78m(k)) prohibits publicly traded issuers from extending personal loans to directors and executive officers, with limited exceptions for loans made in the ordinary course of a consumer credit business on market terms. This provision was enacted in response to corporate scandals involving excessive executive loans that were subsequently forgiven.

State corporate law imposes its own requirements. Under the Delaware General Corporation Law (DGCL) Section 143 and the Model Business Corporations Act (MBCA) Section 8.32, corporations may make loans to directors with board authorization, provided the board determines the loan is reasonably expected to benefit the corporation. Directors with a personal interest in the loan must typically recuse themselves from the board vote to avoid self-dealing and breach of fiduciary duty claims.

A Director's Loan Agreement is needed whenever a corporation makes a loan to one of its directors, or a director lends personal funds to the corporation, and the transaction is separate from the director's salary, dividends, or expense reimbursements.

Common situations requiring a Director's Loan Agreement include: a director of a closely held corporation withdrawing funds for personal use in anticipation of a future dividend declaration; a founding director providing bridge financing to the company during a startup phase or cash flow shortfall; a company providing a relocation loan to a newly appointed director; a director advancing funds to the company to cover a short-term working capital need; and a company formalizing an existing informal arrangement under which the director has been borrowing from or lending to the company without documentation.

A written Director's Loan Agreement is essential for several reasons. First, IRC Section 7872 requires that loans between a corporation and its shareholder-directors bear interest at or above the AFR to avoid imputed interest treatment. A written agreement documenting the interest rate, repayment terms, and drawdown date provides evidence that the parties intended a bona fide loan rather than a disguised distribution. Second, the IRS may recharacterize a purported loan as a constructive dividend if the arrangement lacks the hallmarks of a genuine loan (written agreement, fixed repayment date, adequate interest, actual repayments). Third, state corporate law requires board authorization for loans to directors, and a written agreement supports compliance with fiduciary duty requirements. Fourth, for companies preparing for a financing round, acquisition, or IPO, due diligence will reveal any undocumented related-party transactions, which can delay or derail the transaction.

A Director's Loan Agreement for a US corporation should contain several key provisions to confirm compliance with federal tax law and state corporate law.

The parties clause should identify the corporation (by full legal name, state of incorporation, and principal office address) and the director (by full legal name and residential address). The loan direction (company-to-director or director-to-company) should be clearly specified.

The loan amount and drawdown clause should state the principal sum in figures and words, specify the method of advance (wire transfer, ACH, check, or credit to shareholder loan account), and confirm the drawdown date.

The board approval clause should confirm that the board of directors has authorized the loan by resolution, state the date of the resolution, and confirm whether the company is publicly traded (triggering Sarbanes-Oxley Section 402 restrictions).

The interest clause should specify the annual interest rate, which must equal or exceed the Applicable Federal Rate (AFR) under IRC Section 7872 to avoid imputed interest treatment. The AFR varies by loan term (short-term, mid-term, long-term) and is published monthly by the IRS.

The repayment clause should set out the repayment schedule: lump sum on a fixed date, regular instalments, or on demand. A fixed repayment date with evidence of actual repayments supports bona fide loan treatment.

The tax acknowledgment clause should reference IRC Section 7872 and the constructive dividend rules, and confirm that each party is responsible for their own tax obligations.

The default clause should address acceleration of the loan upon default and specify the default interest rate.

The governing law clause should specify the governing state law and include a severability provision.