Intercompany Loans: A Handshake Isn’t Enough

Article Summary:

Intercompany loans are transfers of funds between related entities, offering speed and flexibility. To avoid severe tax and legal risks, they must be documented with the same formality as an external bank loan. You should not make them interest-free, as the IRS will impute interest (taxing the lender on income it didn't receive). Always charge at least the Applicable Federal Rate (AFR) and document the loan with a formal Promissory Note and Board Resolutions to protect your corporate veil.

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If you’re an entrepreneur in Pennsylvania with multiple related entities, you know that managing cash flow across your business structure is vital. When one company is flush with cash and another needs capital to seize an opportunity or meet short-term obligations, an intercompany loan often becomes the most efficient solution.

What are Intercompany Loans and Why Use Them?

An intercompany loan (sometimes called an intracompany loan) is a financing arrangement, commonly done informally, where one legal entity within your corporate family lends funds to another. While the entities are related, it is crucial that the transaction be structured as a legitimate, formal debt obligation—just as if the borrower were seeking capital from an external bank.

Types of Intercompany Loans

These transactions typically fall into three categories based on the relationship between the entities:

1. Parent-to-Subsidiary: A holding company or parent entity lends money to one of its operating subsidiaries.

   
   

2. Subsidiary-to-Parent: A cash-rich subsidiary lends money up to the parent company.

   
   

3. Sister Company (or Affiliated) Loans: Two entities with common ownership—such as two LLCs owned by the same managing member or two subsidiaries under the same parent—lend to each other.

The Benefits of Lending Within the Family

Why opt for an intercompany loan instead of external bank financing? For related Pennsylvania businesses, the advantages are significant:

• Speed and Efficiency: You can transfer funds quickly without lengthy bank underwriting, approval processes, or external closing costs.

  
  

• Flexibility in Terms: You have greater control over the interest rate, repayment schedule, and maturity date, allowing you to tailor terms to the borrower's specific cash flow needs.'

  
  

• Cost Savings: You avoid bank fees, commitment charges, and generally benefit from an interest rate that is often more favorable than commercial bank financing.

  
  

• Capital Allocation: It allows you to strategically and efficiently move capital from a cash-rich entity to one that needs funding for growth, R&D, or working capital.

Can Intercompany Loans Be Interest-Free? (The Imputed Interest Trap)

The short answer is: Legally, yes, you can make an interest-free loan, but for tax purposes, you almost certainly shouldn't.  The key regulatory hurdle here is the IRS's rule on imputed interest (specifically, under Internal Revenue Code Section 7872 and the principles of Section 482).

The IRS views transactions between related parties—including your sister companies—through an "arm's-length" lens. This means they assume the transaction should reflect what two unrelated parties would agree to. Since an independent bank would never give your business an interest-free loan, the IRS expects a related-party loan to bear a minimum rate of interest.

• The Problem: If you charge no interest, or interest below the Applicable Federal Rate (AFR) published monthly by the IRS, the IRS may impute (assume) the market-rate interest you should have charged.

  
  

• The Consequence: The lending entity is then treated as having received this "imputed interest" income and must pay tax on it, even though no money was ever collected. This can create an unexpected and costly tax liability.

Best Practice: To avoid triggering imputed interest and potential IRS scrutiny, always charge a commercially reasonable rate of interest that is at least equal to the current Applicable Federal Rate (AFR) for a loan of comparable term.

Should Intercompany Loans Be Documented and Why?

Absolutely, without exception. Failing to document an intercompany loan is one of the biggest mistakes related entities can make.

Why Documentation is Crucial:

1. Tax Defensibility (Debt vs. Equity): The IRS and Pennsylvania Department of Revenue will closely scrutinize undocumented transfers. Without a formal agreement, a "loan" can easily be reclassified as a capital contribution (equity) or a dividend distribution.

   • If it's reclassified as a capital contribution, the borrower loses the ability to deduct "interest" payments.

   • If it's reclassified as a dividend, the recipient may have unexpected taxable income.

   • Proper documentation helps establish a true debtor-creditor relationship, preserving the favorable tax treatment of debt.

     
     

2. Fiduciary Duty and Corporate Formalities: As an owner of multiple entities, you have a fiduciary duty to each company's stakeholders (which may include minority owners or external creditors). Pennsylvania law requires you to treat each entity as a separate legal person. Undocumented, "sloppy" transactions blur the lines between your companies, putting you at risk of piercing the corporate veil. If one company is sued, the lack of distinction could allow a court to hold a related entity (or you, personally) liable for the debt.

   
   

3. Audits and Financial Reporting: Your accountants and future lenders will demand clarity. Properly documented loans simplify financial reporting, balance sheet accuracy, and due diligence for any future sale or external financing.

Using Intercompany Loans for Asset Protection

If the borrower company owns real estate, you might consider recording a mortgage against the borrower real estate as an asset protection technique.  One goal of asset protection is to convert your unencumbered assets into debt-ridden assets worthless to a plaintiff.

Equity stripping or encumbering an asset removes its value from potential litigants who may be looking to cash in on your hard-earned wealth through a frivolous lawsuit. Encumbering your assets reduces the equity your creditor can seize. You may have multiple investments but your equity in those investments is minimal due to liens, or mortgages. You can do this with all assets which are not protected, such as second homes, collectibles, vehicles, etc. You can lien your assets separately or give a blanket lien to one creditor. Similarly, you can equity strip the assets in your business or professional practice. The goal is to leave no asset unencumbered and exposed.

Best Practices for Documenting and Making Intercompany Loans

To ensure your intercompany loans are treated as legitimate debt by the IRS, Pennsylvania courts, and potential third parties, follow these best practices for every transaction:

1. Execute a Formal Written Agreement

The foundation of a legitimate loan is a comprehensive Intercompany Loan Agreement and a signed Promissory Note. This document should contain all the material terms you would find in a bank loan:

• Lender and Borrower Identification: Use the full, correct legal name of each entity.

  
  

• Loan Principal: The exact amount of the loan.

  
  

• Interest Rate: Specify the rate (at least the AFR) and how it is calculated (e.g., compounded annually, semi-annually).

  
  

• Repayment Schedule: Detail specific dates for interest and principal payments. Avoid "on-demand" or vague terms, as this looks less like a true loan.

  
  

• Maturity Date: A definitive date when the entire loan balance is due.

  
  

• Events of Default: Clear terms for when the loan is considered defaulted (e.g., missed payments).

  
  

• Governing Law: State that the laws of Pennsylvania govern the agreement.

2. Follow Corporate Formalities

The loan should be authorized by the governing body of each company (e.g., the board of directors or managing members). Document this:

• Board Resolutions: The minutes of the board or manager meetings for both the lending entity and the borrowing entity should reflect the approval of the loan terms. This demonstrates that the transaction was made in the best interest of each separate company.

  
  

• Authorized Signatories: The agreement and note must be signed by an officer or authorized representative of each entity.

  
  

3. Maintain Consistent Financial Records

The documentation is useless if the companies don't adhere to the terms:

• Timely Payments: The borrower must make all interest and principal payments on time and exactly as specified in the Promissory Note. Use dedicated transfers to track these payments clearly.

  
  

• Separate Accounts: Maintain meticulous books and records for each entity. The loan should be clearly recorded as a Note Receivable on the lender's books and a Note Payable on the borrower's books.

  
  

• Annual Reconciliation: Reconcile the intercompany balance annually to ensure both entities' books match.

Intercompany lending is a powerful tool for your Pennsylvania businesses, offering flexibility and efficiency. However, treating these internal transactions with the utmost formality and adherence to arm's-length principles is the best way to safeguard your companies from tax penalties and legal exposure.

Need help drafting or reviewing your Intercompany Loan Agreements to ensure they meet the latest IRS and Pennsylvania compliance standards? Contact Fiffik Law Group today to schedule a consultation.