Intercompany Loans Between Your LLCs: How to Document Them So the IRS Respects Them

An owner runs three LLCs: an operating company, a holding LLC, and a real estate LLC. The operating company has cash. The real estate LLC needs $200,000 to close on a property. The owner wires the money from one to the other and books it as a "loan to affiliate" on the QuickBooks balance sheet.

If the IRS examines that transaction, the agent will not see a loan. The agent will see a distribution from the operating company to the owner followed by a contribution from the owner to the real estate LLC, recharacterized as ordinary income, taxable distribution, or in the worst case a constructive dividend with a 20% accuracy penalty. The label "intercompany loan" in the bookkeeping software does not control. The documentation does.

What Makes a Loan a Loan

The IRS uses a multi-factor test to decide whether a transfer between related parties is a loan or something else. Three factors matter more than the rest.

The first is a written promissory note signed at the time of the transfer. The note specifies the borrower, the lender, the principal amount, the interest rate, the maturity date, the payment schedule, and the consequences of default. No note, no loan. A note signed two years later when an audit notice arrives is worthless.

The second is an interest rate at or above the applicable federal rate (AFR) for the term of the loan. The AFR is published monthly by the IRS in Rev. Rul. notices. Short-term, mid-term, and long-term AFRs apply based on whether the maturity is under three years, three to nine years, or over nine years. Loans below AFR get imputed interest under §7872, which the IRS treats as income to the lender and additional contribution by the borrower, with messy tax consequences for both.

The third is actual repayment on the schedule the note specifies. A note that says monthly payments of principal and interest start in 90 days and never produces a single payment does not survive scrutiny. Even modest payments, made consistently and tracked in the books of both entities, establish the substance.

What Most Owners Get Wrong

The first miss is failing to charge interest. Many owners want to move cash without creating taxable income. The §7872 imputation rules will create the income anyway, and the agent will assess penalties on top because no return reported it. Charging the AFR rate (currently in the 4% to 5% range for mid-term loans) is cleaner.

The second miss is failing to document the use of funds. If the real estate LLC borrows $200,000 and immediately distributes $200,000 to the owner for personal use, the loan is at high risk of recharacterization because the actual flow of funds went to the owner. Trace the cash from lender to borrower to a documented business use.

The third miss is failing to update the books of both entities. The lender LLC must show a note receivable on its balance sheet, interest income on its P&L, and an amortization schedule in its workpapers. The borrower LLC must show a note payable, interest expense, and the same amortization schedule. When the two sets of books do not tie, the agent has a wedge to open the structure.

The Three Documents to Have on File

Before any cash moves, three documents need to exist in the file. A signed and dated promissory note with terms at or above AFR. A board or member consent (depending on the operating agreement) authorizing the loan from each entity. An amortization schedule the bookkeeper updates monthly as payments are made.

If you have moved cash between your LLCs in prior years without these documents, talk to your CPA about a cleanup before the next return is filed. Restructuring a series of undocumented transfers into a properly papered intercompany loan is possible. Doing it during an active audit is not.