Can an LLC Loan Money to an Individual?

Limited Liability Companies (LLCs) offer business owners a flexible structure that separates personal assets from business liabilities. An LLC’s distinct legal entity status allows it to engage in various financial activities, including lending money. Understanding the parameters and requirements for an LLC to extend a loan to an individual is essential for maintaining legal compliance and financial integrity.

Legal Authority for LLC Loans

An LLC generally possesses the legal capacity to make loans, provided such an activity aligns with its governing documents and state regulations. The LLC’s operating agreement outlines its internal operations and management, including its ability to conduct financial transactions. If the operating agreement permits, or does not explicitly restrict, lending activities, the LLC can proceed.

The operating agreement should be reviewed for any specific provisions or limitations on lending money. Some agreements might require member approval for loans exceeding a certain amount or specify conditions for such transactions. Lending money should not constitute an LLC’s primary business activity unless it is specifically licensed as a lending institution. This ensures the loan is considered an ancillary financial transaction rather than an unregulated lending operation.

Establishing a Bona Fide Loan

For a financial transfer from an LLC to an individual to be recognized as a legitimate loan by tax authorities, it must meet specific criteria demonstrating an actual intent for repayment. Without these elements, the Internal Revenue Service (IRS) may recharacterize the transaction, potentially treating it as a taxable distribution, compensation, or even a gift. Both the LLC and the individual must genuinely intend for the money to be repaid, establishing a true creditor-debtor relationship.

A legitimate loan typically includes a fixed maturity date, a clear date by which the entire loan must be repaid. The loan should also carry a reasonable interest rate, often at least equal to the Applicable Federal Rates (AFRs) published monthly by the IRS. These rates serve as minimum interest thresholds to prevent the IRS from imputing interest income or reclassifying the loan as a gift. The AFR varies based on the loan’s term: short-term (up to three years), mid-term (three to nine years), or long-term (greater than nine years).

A defined repayment schedule, detailing how and when repayments will occur, further supports the loan’s legitimacy. While not always mandatory, providing adequate security or collateral can strengthen its bona fide nature, especially for larger sums. This demonstrates the lender’s right to enforce payment. Consistent records maintained by both parties reflecting the transaction as a loan are also important.

Tax Considerations for LLC Loans

The tax implications of an LLC loan impact both the lending entity and the individual borrower. For the LLC, any interest income received from the loan is generally considered ordinary income. This income flows through to the LLC members and is typically taxed at their individual income tax rates. Proper classification of the transaction is essential to avoid adverse tax consequences.

A significant risk for an LLC is the potential for the IRS to “recharacterize” the loan if it does not meet bona fide criteria. If recharacterized, the loan could be treated as a taxable distribution to an LLC member (if the individual is a member), compensation (if the individual is an employee), or a gift. Such recharacterization can lead to unexpected tax liabilities, including income tax on the deemed distribution or compensation, and potentially employment taxes. For instance, if a loan to a member is canceled, the canceled amount becomes taxable income to the borrower.

For the individual borrower, interest paid on the loan may or may not be tax-deductible. Generally, interest on personal loans is not deductible unless the loan proceeds are used for specific purposes. Deductible uses typically include business expenses, qualified education expenses, or eligible taxable investments. If the loan proceeds are used for a mix of purposes, only the interest attributable to the deductible portion can be claimed.

Formalizing the Loan Agreement

Formalizing an LLC loan requires specific documentation to ensure its legal enforceability and adherence to the bona fide criteria. The primary document for this purpose is a promissory note, which serves as the borrower’s written promise to repay the debt to the LLC. This note must clearly state the principal loan amount, interest rate, repayment schedule, maturity date, and identify both the lender and borrower along with their addresses.

For more complex loans or larger amounts, a comprehensive loan agreement may be used in addition to or in place of a simple promissory note. A loan agreement provides more detailed terms, including covenants, conditions for default, and remedies for non-payment, offering greater legal protection to both parties. It can specify whether the interest rate is fixed or variable and how interest is calculated. While a promissory note is often suitable for straightforward, smaller loans, a loan agreement is generally preferred for substantial financial transactions.

If the loan is secured, a security agreement is necessary. This document grants the LLC a security interest in specific assets pledged by the borrower as collateral, allowing the LLC to seize and sell the collateral in case of default. The security agreement mitigates the lender’s risk and can influence the loan’s terms, such as the interest rate. Formal approval from the LLC’s members or managers is typically required, especially in multi-member LLCs. This approval, often documented in meeting minutes or through written consent, confirms the LLC’s authority to enter into the loan and ensures all members are aware of and agree to the transaction.