Yes, your business can loan money to another business. Any company is free to lend to another, and it happens constantly when one entity has idle cash and another needs capital. The catch is that the IRS will only treat the arrangement as a loan if it looks like one on paper and behaves like one in practice. Weak documentation, a below-market interest rate, or a lender that never bothers to collect can turn what you called a loan into a taxable distribution or a disguised equity investment, with back taxes and penalties attached.
What Makes It a Real Loan in the IRS’s Eyes
The IRS and federal courts decide whether a transfer between businesses is genuinely a loan by asking whether the parties intended to create an unconditional obligation to repay, and whether the paperwork would look normal to an outside lender.1Internal Revenue Service. IRS Chief Counsel Memorandum 2006-001 A handshake or an email thread will not survive that test.
The starting point is a written promissory note. It needs to state the principal amount, a fixed maturity date, a stated interest rate, and a repayment schedule tied to specific dates. Repayment cannot depend on whether the borrower turns a profit. A note that only requires payment when the borrower has spare cash reads as an equity stake, not a debt.
If either party is a corporation, the loan should be authorized by a board resolution before any money moves. The resolution should record the business purpose, the approved terms, and which officers can sign. This step is easy to skip and almost impossible to recreate credibly after an audit begins.
Both companies then have to book the transaction consistently. The lender carries a loan receivable, accrues interest income, and records each payment received. The borrower carries a loan payable, accrues interest expense, and records each payment made. Mismatched entries between the two sets of books are among the easiest things for the IRS to flag.
Documentation alone is not enough. The lender has to enforce the note the way a bank would: track payments, send notices when they are missed, and pursue whatever remedies the note allows. Courts have consistently held that the right to enforce repayment and the actual exercise of that right are among the most telling indicators of a real debt. A lender that never picks up the phone about a skipped payment is telling the IRS the loan was never serious.
Setting the Right Interest Rate
Every intercompany loan needs to charge interest, and the rate matters more than most owners realize. A zero-percent or below-market loan does not save tax. The IRS will impute the interest you should have charged and tax you on it as if you had received it.
The Applicable Federal Rate
Each month the IRS publishes Applicable Federal Rates based on yields of U.S. Treasury securities. AFRs come in three tiers set by loan term: short-term for loans of three years or less, mid-term for loans over three years through nine years, and long-term for loans over nine years.2eCFR. 26 CFR 1.482-2 – Determination of Taxable Income in Specific Situations As of March 2026, the annual-compounding AFRs are 3.59% short-term, 3.93% mid-term, and 4.72% long-term.3Internal Revenue Service. Rev. Rul. 2026-6 Rates change monthly, and you lock in based on the month the loan originates.
The Safe Harbor Range
Treasury regulations give related-party loans a safe harbor: any rate between 100% and 130% of the AFR for the applicable term is automatically treated as arm’s length.2eCFR. 26 CFR 1.482-2 – Determination of Taxable Income in Specific Situations Stay in that band and the IRS cannot adjust the rate. For a mid-term loan originated in March 2026, the safe harbor runs from 3.93% to 5.12% on an annual-compounding basis.3Internal Revenue Service. Rev. Rul. 2026-6
Charge less than 100% of the AFR and the IRS imputes interest at 100% of the AFR, compounded semiannually. Charge more than 130% and the rate gets pushed back to 130%, also compounded semiannually, unless you can independently prove a higher rate is justified.2eCFR. 26 CFR 1.482-2 – Determination of Taxable Income in Specific Situations Most businesses simply pick a rate in the middle of the band and avoid the fight.
Record the exact AFR you used, the month it came from, and the loan term that determined which tier applies. If the note calls for periodic rate resets, each reset uses the AFR from the month of the adjustment. Reaching back to a prior month for a lower rate is not allowed.
How Both Sides Report the Loan on Taxes
Once the loan is properly structured, the tax treatment is straightforward. The lender reports interest received as ordinary income: corporations on Form 1120, partnerships on Form 1065, and sole proprietors on Schedule C. Cash-basis lenders recognize interest when the payment arrives. Accrual-basis lenders book it as it accrues, whether or not a check has come in.
The borrower gets the mirror. Interest paid on a legitimate business loan is deductible under IRC Section 163(a).4Office of the Law Revision Counsel. 26 U.S. Code 163 – Interest Both sides should confirm the interest they report matches. A mismatch between the lender’s interest income and the borrower’s interest deduction is easy for IRS systems to spot.
The Business Interest Deduction Cap
The borrower’s interest deduction is not unlimited. Section 163(j) caps net business interest expense at the sum of the borrower’s business interest income, 30% of its adjusted taxable income, and any floor plan financing interest.4Office of the Law Revision Counsel. 26 U.S. Code 163 – Interest For tax years beginning after 2021, adjusted taxable income is calculated after subtracting depreciation, amortization, and depletion, which tightens the cap compared to earlier years.
Interest that exceeds the cap is not permanently lost. It carries forward and is treated as if paid or accrued in the next tax year.5eCFR. 26 CFR 1.163(j)-5 – General Rules Governing Disallowed Business Interest Expense Carryforwards
Small businesses are exempt from the 163(j) cap entirely. A business qualifies if its average annual gross receipts over the three preceding tax years do not exceed the inflation-adjusted threshold, which is $32 million for tax years beginning in 2026.6Internal Revenue Service. Rev. Proc. 2025-32 Most intercompany loans between smaller, privately held businesses fall below that line, and the full deduction is available without running the 30% calculation.
Extra Scrutiny When the Businesses Are Related
When the lending and borrowing businesses share common ownership or control, the IRS treats the transaction as a related-party loan and applies additional scrutiny. Related parties can set whatever terms they want, so the rules force them to behave as if they were strangers.
IRC Section 482 gives the IRS broad authority to reallocate income, deductions, and credits between related businesses whenever an adjustment is needed to prevent tax evasion or clearly reflect each entity’s income.7Office of the Law Revision Counsel. 26 U.S. Code 482 – Allocation of Income and Deductions Among Taxpayers The stated purpose is to put controlled taxpayers on the same footing as uncontrolled ones, so every transaction between them reflects what unrelated parties would have agreed to.8eCFR. 26 CFR 1.482-1 – Allocation of Income and Deductions Among Taxpayers
If the Rate Is Too Low
Lend to a related business below 100% of the AFR and the IRS imputes interest income to the lender at 100% of the AFR.2eCFR. 26 CFR 1.482-2 – Determination of Taxable Income in Specific Situations You owe tax on interest you never collected. The borrower generally gets a matching deduction, so the group’s combined liability may wash, but the lender still faces the added tax, possible penalties, and the paperwork of an adjustment.
IRC Section 7872 can also apply to below-market loans involving corporations and their shareholders, and to any loan where tax avoidance is a principal purpose.9Office of the Law Revision Counsel. 26 U.S. Code 7872 – Treatment of Loans With Below-Market Interest Rates Under 7872, the forgone interest is treated as if the lender transferred it to the borrower, who then paid it back as interest. When two businesses share a common owner, a loan can implicate both Section 482 and Section 7872 depending on how the ownership is structured.
If the Rate Is Too High
Charging above 130% of the AFR creates a different problem. The IRS may recharacterize the excess as something other than interest, such as a constructive dividend from the borrower’s owners to the lender’s owners. The borrower loses the deduction on the excess, and the recipient is taxed on what amounts to a non-deductible distribution. The result can be double taxation.
When the IRS Treats the Whole Thing as Equity
The worst outcome is full recharacterization. If the IRS decides the economic substance looks more like an investment than a loan, the entire arrangement is reclassified as a capital contribution or equity stake. Courts and the IRS apply a multi-factor test, and no single factor is decisive, though a few carry outsized weight.
The Factors That Matter Most
Courts look at whether the borrower was thinly capitalized at the time of the advance, whether a fixed maturity date and repayment schedule exist, whether the lender had the right to enforce repayment and actually exercised it, whether interest was paid on schedule, whether the debt was subordinated to outside creditors, and whether a legitimate business purpose existed beyond tax savings.1Internal Revenue Service. IRS Chief Counsel Memorandum 2006-001 They also examine whether the debt was advanced in proportion to existing equity holdings, because a loan that mirrors ownership percentages looks like paid-in capital.
In practice, enforcement is what sinks most intercompany loans. The note can look perfect on paper, but if the borrower missed twelve payments and the lender said nothing, the IRS has what it needs. Maintaining a paper trail of collection activity costs nothing and provides the strongest evidence that both parties treated the arrangement as real debt.
What Recharacterization Costs
If the loan is reclassified as equity, the tax treatment unravels. The borrower’s interest deductions are disallowed for every open year the loan was outstanding, creating tax deficiencies plus interest and possible penalties. What the borrower called interest payments become non-deductible distributions. What the lender reported as interest income becomes dividend income, taxed at ordinary rates with no matching deduction on the other side.
Principal repayments also change character. Instead of a tax-free return of principal, they are treated as distributions from the borrower, taxable depending on the borrower’s earnings and the recipient’s basis. Once the IRS recharacterizes the transaction, you cannot go back and restructure it. Every defense is preventive: proper documentation, an arm’s-length rate, and consistent enforcement from day one.
Securing the Loan with Collateral
A security interest in the borrower’s assets strengthens the case that a real creditor-debtor relationship exists and gives the lender a legal path to recovery in a default. An unsecured intercompany loan adds one more factor pointing toward equity in any recharacterization analysis.
To create a valid security interest in personal property such as equipment, inventory, or accounts receivable, the two sides sign a security agreement describing the collateral. The lender then perfects the interest by filing a UCC-1 financing statement with the secretary of state in the borrower’s jurisdiction.10Legal Information Institute. UCC Financing Statement Filing establishes priority over other creditors who may later claim the same assets. A UCC-1 that names the borrower correctly and describes the collateral adequately is generally effective even with minor errors, unless the mistakes are seriously misleading.
The statement can cover specific assets or serve as a blanket lien on all current and future business property. A blanket lien offers broader protection but can complicate the borrower’s ability to obtain outside financing, since new lenders will see the existing claim. Filing fees vary by state but typically run between $5 and $60.
If the Borrower Cannot Repay
When a business loan goes bad, the lender may be able to deduct the loss. IRC Section 166 allows a deduction for any debt that becomes wholly or partially worthless during the tax year.11Office of the Law Revision Counsel. 26 U.S. Code 166 – Bad Debts A business bad debt is one created or acquired in connection with the lender’s trade or business, or one whose loss from worthlessness is incurred in the lender’s business.
To claim the deduction you need to show that you took reasonable steps to collect and that no realistic expectation of repayment remains. A lawsuit is not required if a court judgment would obviously be uncollectable.12Internal Revenue Service. Topic No. 453, Bad Debt Deduction Wholly worthless debts are deducted in full in the year they become worthless. Partially worthless debts can be deducted to the extent the lender writes off the uncollectible portion on its books.
The deduction only works if the IRS respects the arrangement as a genuine loan. If the transaction was never properly documented and gets recharacterized as equity, there is no bad debt deduction. The lender’s only recovery at that point is a capital loss on a worthless investment, which is far less favorable.
Licensing, Usury, and Other Boundaries
Most states regulate the business of lending, and a company that makes loans regularly may need a lending license. The threshold varies. Some states exempt businesses that make only a handful of commercial loans a year or where lending is incidental to the primary operations. A one-time loan to a business partner is unlikely to trigger a licensing requirement, but a pattern of lending activity could. Check with the state financial regulator in both jurisdictions before funding.
Usury laws are less of a concern for commercial lending. Most states either exempt business-purpose loans from their usury caps or set significantly higher limits for commercial transactions than for consumer credit. That exemption typically depends on the loan being genuinely commercial. If the funds are used for personal purposes despite being structured as a business-to-business transaction, consumer usury protections may still apply.