Related-Party Loans: Casual Cash Transfers Can Raise Tax Questions
It is not unusual for business owners to provide temporary loans to their companies, or for businesses under common ownership to lend money back and forth. In most cases, the intention is straightforward: to bridge a gap in operations, fund a new opportunity, or cover a temporary cash shortfall. The funds are considered a loan and repaid when financial conditions allow.
But unless such related-party loans are properly documented, managed, and reported for accounting and tax purposes, the IRS may not consider them loans at all. Instead, they could be reclassified as capital contributions or investments, with significant tax consequences for both the business itself and the individual shareholders, partners, or owners.
When Is a Loan Not a Loan?
To be treated as bona fide debt, a loan between related parties must be supported by objective evidence that a true debtor-creditor relationship exists. This is true regardless of whether the loan is from an individual to a business or between two business entities under common control.
Various deficiencies can cause the IRS to question whether a transaction is a legitimate loan. Chief among these is the lack of a signed promissory note, or a note that is signed long after the funds are transferred. An informal note drawn up without professional legal review and notarized signatures can be a red flag for auditors.
Another common feature of many related-party loans is failure to charge an adequate interest rate—or charging no interest at all. Every month, the IRS calculates the Applicable Federal Rate (AFR), which reflects the minimum interest rates that must be used for loans and other transactions between related parties. The rates vary depending on the loan’s term—short-term (less than 3 years), mid-term (3 to 9 years), or long-term (more than 9 years). The AFR is well below typical market rates and it changes monthly based on the average market yield of US Treasury securities with similar maturity periods.
Other potential issues include improper accounting treatment, such as recording interest only at the end of the year rather than in accordance with the loan terms, and misclassifying the loan on financial statements or tax returns. Grouping a related-party loan in with regular accounts payable is another common mistake.
In many audits, it is not a single failure that causes concern, but rather a series of such missteps that collectively cast doubt on the legitimacy of the loan.
What Happens if a Loan Is Reclassified?
If the IRS determines a loan between related parties lacks sufficient documentation or commercial substance, it may reclassify the transaction as a capital contribution or equity investment and classify any repayment as a capital distribution. Such a finding will have significant tax consequences:
- The business will lose the interest deduction, increasing its taxable income.
- For the lender—either an individual or a related company—any repayment received will be treated as a distribution (if a partnership or LLC) or a taxable dividend (if a corporation), rather than a tax-free loan repayment.
- If the funds are not repaid, the lender will be unable to claim a bad debt deduction.
In partnerships and LLCs, such reclassification can also affect partner basis, capital accounts, and the allocation of recourse or nonrecourse debt. In corporations, it could turn an otherwise tax-neutral repayment into taxable income for the owner or entity receiving the payments.
Avoiding Trouble: Documentation Is Key
The following checklist can help ensure that related-party loans—whether from business owners or related companies—meet the IRS’s expectations:
- Written promissory note. The note should be prepared or at least reviewed by an objective third-party professional. It should clearly state the principal amount, interest rate, repayment terms, and final due date. Ideally, signatures from all parties should be notarized and executed on the same date that the funds are transferred and the relevant journal entries are made.
- Adequate interest rate. The rate should be at least equal to the IRS Applicable Federal Rate in effect at the time the loan is made. Monthly AFR updates can be found at Applicable federal rates (AFRs) rulings.
- Timely and consistent accounting. Interest accruals and payments should be recorded regularly, in accordance with the note’s terms. A one-time, year-end interest entry or account credit can be a red flag during an audit.
- Accurate classification. Related-party loans should be properly recorded on the company’s balance sheet. Avoid the common shortcut of recording a note payable along with ordinary accounts payable, which can affect how and where the debt appears on federal tax documents.
- Periodic review. All parties to the transaction should review the loan terms and performance regularly—at least annually—to confirm that the terms are still appropriate and are being followed. This review should be documented in meeting minutes or other records that could be available in the event of an audit.
Above all, companies should take care that any related-party loans actually function as loans, rather than equity contributions. A note payable or intercompany loan that appears on the books every year with no change is most likely not a legitimate debt but a long-term investment. The prudent approach would be to reclassify such debt as equity now, rather than waiting for the IRS to notice and force compliance.
Please contact us if you have questions about related-party loans or other tax-related transactions.
