Can I Borrow Money From My Company?

Borrowing money from a company you own or work for involves navigating complex regulations and tax rules. Treating these internal financial arrangements casually can lead to significant unintended consequences for both the individual and the company. Proper structuring and adherence to specific guidelines are necessary to ensure the transaction is recognized as a legitimate loan by tax authorities, preventing future complications and potential penalties.

Requirements for a Valid Loan

For a financial transaction between an individual and their company to be considered a true loan, rather than a disguised distribution or compensation, several key characteristics must be present. The Internal Revenue Service (IRS) scrutinizes these arrangements closely, particularly when the borrower and lender are related parties. A fundamental element is the clear intent to repay the borrowed funds, which must be evident from the transaction’s inception and throughout its duration. Without this clear intent, the IRS may argue the funds were never truly a loan.

A legitimate loan requires a reasonable interest rate, reflecting an arm’s-length transaction. The IRS publishes Applicable Federal Rates (AFRs) monthly, which serve as minimum interest rates for various loan terms, categorized as short-term (up to three years), mid-term (more than three but not over nine years), and long-term (over nine years). Charging at least the appropriate AFR helps avoid the IRS recharacterizing the transaction as a taxable event, such as a gift or compensation, due to a below-market interest rate. If the interest rate falls below the AFR, the IRS may impute interest, treating the difference as if it were paid, which can create unexpected taxable income.

A fixed repayment schedule with specified payment amounts and due dates is important. This schedule demonstrates a commitment to repayment and provides a clear framework for the loan’s term. While not always mandatory, providing collateral can further support the classification of the transaction as a bona fide loan, demonstrating a clear security interest for the company. The borrower’s ability to repay the loan based on their financial capacity, considering their annual compensation and other assets, is also a significant factor the IRS considers when evaluating the validity of the loan.

Tax Treatment of Company Loans

The tax implications of borrowing money from your company vary significantly depending on whether the loan is structured and maintained correctly, as well as the company’s legal structure. If a loan is properly established and adhered to, the company generally recognizes the interest received as taxable income. The individual borrower, if the interest is paid, may be able to deduct it depending on how the loan proceeds are used, such as for qualified residence interest or investment interest. Principal repayments are typically not considered taxable income to the individual, as they represent a return of the loan principal.

If the loan fails to meet the criteria for a bona fide debt, the IRS can recharacterize the transaction, leading to adverse tax consequences for both parties. For C corporations, an improperly structured or maintained loan might be reclassified as a taxable dividend to the shareholder. This means the individual would owe ordinary income tax on the amount received, and the corporation would not receive a tax deduction for the distribution, unlike interest payments which are generally deductible. Alternatively, the IRS could reclassify the amount as compensation, which would be taxable income to the individual and subject to federal payroll taxes (Social Security and Medicare) for both the individual and the company. While the company might deduct compensation expenses, the payroll tax burden remains.

For S corporations or LLCs taxed as partnerships, recharacterization of a loan can also have significant tax ramifications. Payments from these pass-through entities, if reclassified from a loan, might be treated as distributions that reduce the owner’s tax basis. Distributions up to an owner’s basis are generally tax-free, but distributions exceeding basis are typically taxed as capital gains. If a loan is deemed a capital contribution, the company loses any interest deduction, and principal repayments are treated as distributions, potentially leading to taxable income for the shareholder. If a company lends money below the AFR, the IRS may impute interest under Section 7872, treating the difference as if paid and creating taxable income for both the company and individual, even without cash exchange, which can trigger complex calculations.

Essential Documentation and Formalities

Proper documentation and adherence to formalities are necessary to support the legitimacy of a company loan and avoid adverse tax recharacterization. A formal, written promissory note is foundational, clearly outlining the principal amount, the specific interest rate (often referencing the AFR), the detailed repayment schedule, and the maturity date of the loan. This document should explicitly establish an unconditional promise to repay and grant the company the legal right to enforce payment, specifying remedies for default. Without such a comprehensive note, the IRS may easily argue the transaction was not a true loan.

For corporations, formal board of directors’ resolutions approving the loan are important, demonstrating that the loan is an official corporate act and not merely a personal withdrawal. For LLCs or partnerships, similar provisions or approvals should be documented within the operating agreement or partnership agreement, detailing the terms and authorization of the loan. Maintaining accurate and detailed accounting records is also necessary, showing the initial loan disbursement, all interest accruals, and every principal and interest payment made by the borrower. These records provide a clear audit trail and support the loan’s authenticity.

The agreed-upon repayment schedule must be consistently followed. Irregular or absent payments can undermine the loan’s validity, regardless of initial documentation, making it susceptible to recharacterization by tax authorities. Any modifications to the loan terms, such as changes to the repayment schedule or interest rate, should also be formally documented through addendums or new agreements, mirroring the initial formality. Proper handling throughout the loan’s life cycle is as important as the initial setup in maintaining its legitimate status.