Can My Business Loan Money to Another Business?

Businesses with excess capital often seek productive ways to utilize their funds. Lending to another business can generate interest income and foster strategic partnerships. However, such transactions come with financial, legal, and tax implications that require careful planning and documentation to ensure compliance and protect both parties.

Regulatory Requirements

Business-to-business lending involves more than simply drafting an agreement and transferring funds. Various federal and state regulations govern these transactions, and noncompliance can lead to penalties or legal disputes. A key consideration is whether your business needs a lending license. While occasional loans may not require one, regularly engaging in lending could subject your company to licensing requirements under state financial laws. For example, California’s Finance Lenders Law mandates a license for commercial lenders unless they qualify for an exemption.

Usury laws, which set maximum allowable interest rates, vary by state. In New York, the civil usury cap is 16% annually, while charging more than 25% can lead to criminal penalties. Violating these limits can result in forfeiting interest payments or facing legal consequences. Businesses should review state statutes before finalizing loan terms.

Federal regulations may also apply, particularly if the loan involves financial reporting or resembles a securities transaction. The Securities and Exchange Commission (SEC) may scrutinize certain lending arrangements, and the Internal Revenue Service (IRS) requires loans between related businesses to follow arm’s length principles. If a loan lacks market-based terms, the IRS may reclassify it as a taxable distribution or contribution.

Loan Terms and Documentation

A well-structured loan agreement protects both parties by clearly defining the principal amount, repayment schedule, interest rate, and any applicable fees. It should also outline consequences for missed payments, such as late fees or default provisions.

Loan duration and prepayment terms should align with both parties’ financial goals. Some businesses prefer short-term loans with higher monthly payments, while others negotiate longer terms to ease cash flow constraints. A prepayment clause can allow early repayment without penalty or impose fees to compensate the lender for lost interest.

A promissory note strengthens the lender’s legal position by detailing payment obligations and the lender’s rights in case of non-payment. For larger loans, lenders may require a personal or corporate guarantee, making an individual or entity liable if the borrowing business defaults.

Collateral Versus Unsecured Lending

The decision to require collateral depends on the lender’s risk tolerance and the borrower’s financial position. Secured loans, backed by assets such as real estate, equipment, or accounts receivable, reduce risk and may offer lower interest rates or extended repayment periods. Lenders typically use a loan-to-value (LTV) ratio to determine the loan amount relative to the asset’s value.

To secure collateral, lenders must comply with the Uniform Commercial Code (UCC), which governs secured transactions in the U.S. Filing a UCC-1 financing statement with the appropriate state agency establishes the lender’s legal claim, preventing other creditors from asserting priority over the same assets. Some assets, such as vehicles or real estate, may also require recording a lien with the appropriate government office.

Unsecured loans rely solely on the borrower’s creditworthiness and cash flow. Without collateral, lenders assume greater risk, leading to stricter qualification requirements and higher interest rates. Credit analysis plays a key role, with lenders reviewing financial statements, debt-to-equity ratios, and cash flow trends to assess repayment ability. A strong balance sheet and stable earnings improve a borrower’s chances of securing an unsecured loan, while high leverage or inconsistent revenue may result in less favorable terms.

Interest Rates and Payment Schedules

Setting an interest rate requires balancing profitability with market competitiveness. Lenders often reference benchmarks such as the Secured Overnight Financing Rate (SOFR) or the prime rate, adjusting for borrower risk, loan duration, and economic conditions. Lower-risk borrowers with strong financials may secure rates closer to market benchmarks, while higher-risk entities may face steeper premiums. Interest can be fixed, offering predictable payments, or variable, fluctuating with benchmark movements. Businesses should assess how economic shifts might impact variable-rate loans, particularly in periods of rising interest rates.

Payment schedules affect cash flow and loan performance. Amortizing loans, where payments cover both principal and interest, gradually reduce outstanding debt, lowering default risk over time. Interest-only structures ease initial borrower obligations but result in a balloon payment at maturity, increasing risk if repayment capacity weakens. Structuring payments to align with a borrower’s revenue cycle, such as seasonal businesses preferring quarterly over monthly payments, can improve consistency and reduce delinquency risk.

Tax and Accounting Considerations

Lending money to another business has tax and accounting implications that must be managed carefully. The loan’s structure affects financial reporting and tax filings, impacting both the lender and borrower. Proper documentation and adherence to tax regulations ensure compliance with federal and state laws.

Interest Income and Deductibility

For the lender, interest earned on the loan is taxable income and must be reported to the IRS. The timing of income recognition depends on the accounting method used. Under the accrual method, interest is recognized as it accrues, even if not yet received, whereas cash-basis taxpayers report income only when payments are collected. If the borrower fails to pay, the lender may be able to write off the unpaid interest as a bad debt deduction under IRS rules, provided the loan was made with a bona fide expectation of repayment.

The borrower may deduct interest payments as a business expense if the loan is used for business purposes. However, if the IRS determines that the loan lacks a legitimate business purpose or is improperly structured, deductions may be disallowed. Additionally, the Tax Cuts and Jobs Act (TCJA) limits business interest expense deductions to 30% of adjusted taxable income for certain businesses, which could affect high-debt borrowers.

Loan Classification and Imputed Interest

The IRS scrutinizes loans between related businesses to ensure they are not disguised as equity contributions or distributions. If a loan lacks formal terms, repayment enforcement, or a reasonable interest rate, the IRS may reclassify it as a capital transaction, triggering unintended tax consequences. Businesses should document the loan with a written agreement, establish repayment terms, and charge an interest rate that meets the Applicable Federal Rate (AFR) to prevent imputed interest.

If a loan is issued at a below-market interest rate, the IRS may impute interest, requiring the lender to report income as if interest had been charged at the AFR. This can create unexpected tax liabilities, particularly in intra-company lending arrangements. Businesses should ensure that loan terms reflect market conditions to avoid IRS scrutiny and potential tax adjustments.