An LLC can loan money to an individual, and the transaction is legal in every state, but it only holds up as a loan if it is documented like one, priced like one, and repaid like one. Without a written agreement, a market interest rate, and a real payment history, the IRS can recharacterize the transfer as a taxable distribution, as compensation, or as a gift, with back taxes and penalties attached. The risk climbs sharply when the borrower is a member of the LLC, and it becomes an outright prohibition when the LLC is owned by a retirement account.
Does the LLC Have Authority to Lend?
The first question is internal. The operating agreement should explicitly authorize managers or members to invest company funds, which includes lending to outside parties. If the agreement is silent, the loan can be challenged as outside the company’s authorized activities. When there is no operating agreement at all, the LLC falls back on the default rules of its state’s LLC act, and those defaults vary.
State usury laws then cap how much interest the LLC can charge. Ceilings differ significantly from state to state, and charging above the cap can void the contract or expose the LLC to penalties under consumer protection statutes.1Legal Information Institute. Wex – Usury
A one-off loan to a friend or relative is unregulated at the federal level. A pattern of lending is not. Under Regulation Z, an entity becomes a “creditor” subject to the Truth in Lending Act’s disclosure rules once it extends consumer credit more than 25 times in the preceding calendar year, or more than 5 times for loans secured by a dwelling.2Consumer Financial Protection Bureau. 12 CFR 1026.2 – Definitions and Rules of Construction Cross that line and TILA’s written disclosures and potential state licensing requirements come with it.3Federal Trade Commission. Truth in Lending Act
What Makes a Transfer a Real Loan
The IRS and the courts look at substance, not labels. A transfer called a “loan” on the books gets reclassified when it lacks the hallmarks of genuine debt. Courts weigh several factors:
- A signed promissory note stating principal, interest rate, maturity date, and repayment schedule.
- A fixed repayment schedule with regular payments. Open-ended or demand notes draw more skepticism.
- An interest rate that is commercially reasonable, at minimum the Applicable Federal Rate.
- A borrower who had the ability to repay when the loan was made.
- An actual payment history, with the LLC enforcing the schedule when payments are missed.
- Collateral or security pledged against the loan.
- Consistent bookkeeping on both sides treating the transaction as debt.
No single factor controls. Courts give more weight to what actually happened than to the paperwork. A perfectly drafted note means nothing if payments never changed hands. Record the loan on the LLC’s balance sheet as a receivable, keep an amortization schedule, and if the borrower misses a payment, respond the way a commercial lender would: send a notice, formally restructure, or begin collection. Looking the other way on missed payments is one of the strongest signals to the IRS that the loan was never real.
Interest Rate: The Applicable Federal Rate
The safest rate is at or above the Applicable Federal Rate, which the IRS publishes each month in a revenue ruling. The AFR has three tiers based on loan term:
- Short-term, up to three years: 3.59% annually as of March 2026.
- Mid-term, over three years and up to nine years: 3.93% annually.
- Long-term, over nine years: 4.72% annually.
These rates change monthly.4Internal Revenue Service. Rev. Rul. 2026-6 – Applicable Federal Rates for March 2026 The rate in effect when a fixed-rate term loan is made locks in for the life of the loan. Current rates are posted on the IRS website.5Internal Revenue Service. Applicable Federal Rates
Charging less than the AFR triggers the imputed interest rules under IRC Section 7872. The IRS treats the shortfall between actual interest and the AFR as a phantom transfer: the lender is deemed to have given the borrower an amount equal to the forgone interest, and the borrower is deemed to have paid that amount back as interest. The lender owes tax on interest income it never actually received.6Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates On the borrower’s side, the imputed amount is characterized as a gift, as compensation, or as a distribution depending on the relationship.
Section 7872 includes a narrow carve-out: if the total outstanding balance between the parties stays at or below $10,000, the imputed interest rules generally do not apply. Two important limits. The exception does not apply if the borrowed funds are used to buy or carry income-producing assets. And the gift-loan version of the exception covers loans “directly between individuals,” which may not shield an LLC-to-individual loan. Even on small loans, charging the AFR is the cleaner approach.
Tax Treatment When the Loan Is Legitimate
Loan proceeds are not taxable income to the borrower. Borrowed money carries an obligation to repay, so there is no net gain.7Office of the Law Revision Counsel. 26 U.S. Code 61 – Gross Income Defined Repayment of principal is not a taxable event for the LLC.
Interest is the taxable piece. The LLC reports interest received as ordinary income on its tax return.8Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses A multi-member LLC taxed as a partnership passes that interest income through to members on Schedule K-1. A single-member LLC reports it on the owner’s Schedule C or other applicable form.
Whether the borrower can deduct the interest depends entirely on how the proceeds are used. Interest on funds used for business operations or qualifying investments is generally deductible. Interest on funds used for personal expenses, including vacations, consumer goods, and everyday living costs, is not.9Internal Revenue Service. Topic No. 505, Interest Expense The deduction follows the use, not the source, so the borrower needs to trace where the money went.
What Reclassification Costs
If the IRS decides the transfer lacks the characteristics of debt, the entire principal becomes a taxable event, retroactive to the year the funds moved. The specific treatment depends on who received the money:
- An LLC member: the amount is treated as a taxable distribution of profits. In a partnership-taxed LLC it reduces basis and can trigger gain. In a corporation-taxed LLC it becomes a constructive dividend.
- An employee or contractor: the amount is treated as compensation, requiring a Form W-2 or Form 1099 and potentially employment taxes.
- An unrelated individual: the amount can be treated as a gift, which creates gift tax exposure for the LLC’s members if the amount exceeds the 2026 annual exclusion of $19,000 per recipient.
Because reclassification is retroactive, the bill typically includes back taxes, interest, and penalties on top of the underlying liability.
Loans to Members: The Highest-Risk Case
Money flowing from an LLC to one of its own owners draws the most IRS attention. The default assumption is that it is a distribution of profits, not a loan. Every item on the documentation list above moves from best practice to requirement.
The usual trigger for recharacterization is behavior: a borrower without the financial ability to repay, sporadic or nonexistent payments, and an LLC that never takes any collection action. Courts care more about objective conduct than about what the note says.
The imputed interest rules bite harder here too. A below-AFR loan to a member taxed as a partner produces imputed interest income that flows through to the members on their K-1s, raising taxable income without producing cash.6Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates In a corporation-taxed LLC, forgone interest becomes a constructive dividend to the shareholder-borrower.
Multi-member LLCs should also obtain written approval from the disinterested members before lending to any member. Operating agreements often restrict interested transactions, and managers who approve personal “loans” without proper authorization can face claims for breach of the duty of loyalty. Even without an explicit restriction, the fiduciary duties members owe each other make undisclosed self-dealing loans risky.
Securing the Loan With Collateral
If the loan is secured, naming collateral in the note is not enough. To gain priority over other creditors and to protect the LLC in the borrower’s bankruptcy, the security interest must be perfected.
For personal property such as equipment, vehicles, or accounts receivable, perfection generally requires filing a UCC-1 financing statement with the secretary of state in the state where the borrower is located. The filing is a public notice of the LLC’s claim. Accuracy matters: a misspelled debtor name can make the filing legally ineffective. UCC-1 filings last five years, and a continuation statement is needed before they lapse. Filing fees vary by state and generally run between $5 and $60.
For real property, the LLC should record a deed of trust or mortgage with the county recorder where the property sits, the same process any mortgage lender follows.
Perfecting the security interest does more than secure priority. It also reinforces the loan’s legitimacy. A lender that does not bother protecting itself against default looks like a lender that never expected repayment, which is the exact conclusion the IRS reaches when it reclassifies loans as distributions.
When the Borrower Doesn’t Pay
If the loan becomes uncollectible, the LLC may be entitled to a bad debt deduction. The rules differ by category.
A business bad debt is one created in connection with the LLC’s trade or business, or closely related to it. Business bad debts can be deducted in full or in part in the year they become worthless.10Internal Revenue Service. Topic No. 453, Bad Debt Deduction
Everything else is a nonbusiness bad debt. These can only be deducted when the debt is totally worthless, with no partial deduction allowed, and the write-off is reported as a short-term capital loss subject to the annual capital loss limits.10Internal Revenue Service. Topic No. 453, Bad Debt Deduction
To claim either deduction, the LLC has to prove two things: the original transfer was intended as a loan rather than a gift, and reasonable collection efforts were made. You do not have to sue a borrower whose judgment would be uncollectible anyway, but walking away without any collection effort undermines the deduction. The write-off is only available in the year the debt becomes worthless, and the LLC needs documentation showing when and why it concluded the borrower would never pay.
A Hard Stop: LLCs Owned by Retirement Accounts
If the LLC is owned by a self-directed IRA or Solo 401(k), the rules change entirely. Some account holders assume an IRA-owned LLC can lend to them personally or to their family. It cannot.
Under IRC Section 4975, any loan between a retirement plan (or an entity it owns) and a “disqualified person” is a prohibited transaction. Disqualified persons include the account holder, their spouse, children, parents, and certain business partners. The prohibition is absolute: good intentions and fair market terms do not matter.11Office of the Law Revision Counsel. 26 U.S. Code 4975 – Tax on Prohibited Transactions
The penalties are severe. The disqualified person owes an excise tax of 15% of the amount involved for each year the transaction remains uncorrected. If it is not unwound during the correction period, an additional 100% tax applies.11Office of the Law Revision Counsel. 26 U.S. Code 4975 – Tax on Prohibited Transactions Worse, a prohibited transaction can disqualify the entire IRA, treating the full account balance as distributed in the year of the violation, which triggers income tax on the whole amount plus a 10% early withdrawal penalty if the account holder is under 59½.
For a retirement-owned LLC, the usable rule is simple: lend to unrelated third parties only, never to yourself, your family, or anyone else who qualifies as a disqualified person.