Yes, an LLC can loan money to an individual, but the transfer has to be structured and documented like a real commercial loan or the IRS can reclassify it as a taxable gift, compensation, or profit distribution. The risk is highest when the borrower is a member of the LLC, because the agency starts from the assumption that money moving from a business to its owner is a distribution rather than debt.
Does Your LLC Have the Authority to Lend?
The starting point is the operating agreement. It should expressly authorize managers or members to invest company funds, which covers lending to outside parties. If the operating agreement is silent, the loan could be challenged as outside the company’s authorized activities. Where no operating agreement exists at all, the LLC runs on the default provisions of the state’s LLC act, and those defaults vary widely from state to state.
Internal authority isn’t the whole picture. State usury laws cap the interest rate a lender can charge, and the ceilings differ by state.1Legal Information Institute. Wex – Usury Charging above the cap can void the contract or expose the LLC to penalties under consumer protection laws.
One boundary worth naming: an occasional loan to a friend, family member, or contact is different from running a lending business. Under federal Regulation Z, an entity becomes a “creditor” subject to Truth in Lending Act disclosures once it extends consumer credit more than 25 times in a calendar year, or more than 5 times for loans secured by a home.2Consumer Financial Protection Bureau. 12 CFR 1026.2 – Definitions and Rules of Construction A one-off loan won’t hit that threshold, but a pattern of lending brings TILA disclosure rules and potential state licensing requirements into play.3Federal Trade Commission. Truth in Lending Act
What Makes It a Real Loan Instead of a Tax Problem
The IRS and the courts look at substance, not labels. A transfer called a “loan” on the books gets recharacterized when it lacks the features of genuine debt. Several factors carry weight:
- A signed promissory note stating principal, interest rate, maturity, and repayment schedule.
- A fixed repayment schedule with defined dates. Open-ended or demand notes draw more skepticism.
- An interest rate that is at minimum the Applicable Federal Rate.
- A borrower with the income or assets to actually service the debt when the loan is made.
- A real repayment history, with the LLC enforcing the schedule when payments are missed.
- Collateral pledged against the loan.
- Consistent bookkeeping treating the transaction as debt on both sides.
No single factor is decisive. Courts weigh the whole picture and give more importance to what actually happened than to how well the paperwork reads. A perfect promissory note means nothing if no payments ever change hands.
Practically, the LLC should record the loan as a receivable, maintain an amortization schedule, and respond to missed payments the way a commercial lender would: send notices, formally restructure, or take collection steps. Looking the other way when a borrower skips payments is one of the strongest signals to the IRS that the loan was never real.
The Interest Rate Floor: Applicable Federal Rates
The safest approach is to charge at least the Applicable Federal Rate, which the IRS publishes monthly. The AFR varies by loan term. As of March 2026:
- Short-term (up to 3 years): 3.59% annually
- Mid-term (over 3 years, up to 9 years): 3.93% annually
- Long-term (over 9 years): 4.72% annually
The rates change each month.4Internal Revenue Service. Rev. Rul. 2026-6 – Applicable Federal Rates for March 2026 The rate that applies is the one in effect when the loan is made, and it locks in for the life of a fixed-rate term loan. Current rates are published 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 the AFR interest and the actual rate 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 the imputed interest income even though no cash changed hands.6Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates The forgone interest on the other side may be treated as a gift, compensation, or a distribution depending on the relationship.
The $10,000 De Minimis Exception
Section 7872 includes a narrow carve-out for small loans. If the total outstanding balance between the parties stays at or below $10,000, the imputed interest rules generally don’t apply. Two limits: the exception doesn’t apply if the borrowed funds are used to buy or carry income-producing assets, and the gift-loan version of the exception specifically covers loans “directly between individuals,” which may not shield an LLC-to-individual loan.6Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates Even for small loans, charging at least the AFR is the cleaner path.
Tax Treatment on Both Sides
Properly structured, the tax picture is straightforward. Loan proceeds aren’t taxable income to the borrower, because borrowed money carries an obligation to repay.7Office of the Law Revision Counsel. 26 U.S. Code 61 – Gross Income Defined Repayment of principal isn’t taxable to the LLC either.
Interest is where tax obligations arise. The LLC reports interest received as ordinary income.8Internal Revenue Service. Publication 550 (2025), Investment Income and Expenses How that income reaches the owners depends on the LLC’s tax classification. A multi-member LLC taxed as a partnership passes interest income through to members on Schedule K-1. A single-member LLC reports it on the owner’s Schedule C or another applicable form.
The borrower’s ability to deduct interest depends entirely on how the loan proceeds are used. Interest on funds used for business operations or qualifying investments is generally deductible. Interest on funds used for personal expenses — a vacation, consumer goods, everyday living — is not.9Internal Revenue Service. Topic No. 505, Interest Expense The deduction follows the purpose of the money, so the borrower needs to trace the funds to their end use.
What Happens If the IRS Reclassifies the Loan
If the IRS decides the transaction lacks the characteristics of genuine debt, the entire principal is recharacterized as a taxable event. The result depends on the borrower’s relationship to the LLC:
- For an LLC member, the amount is treated as a taxable distribution of profits. In a partnership-taxed LLC it reduces the member’s basis and may trigger gain; in a corporate-taxed LLC it becomes a constructive dividend.
- For an employee or contractor, it’s treated as compensation, requiring a Form W-2 or Form 1099 and potentially triggering employment taxes.
- For an unrelated individual, it may be treated as a gift, which can create gift tax exposure for the LLC’s members if the amount exceeds the annual exclusion of $19,000 per recipient in 2026.
Reclassification is retroactive to the year the funds were transferred, which typically means back taxes, interest, and penalties layered on top of the underlying tax bill.
Extra Scrutiny for Loans to LLC Members
Loans from an LLC to one of its own members draw the most IRS attention. The starting assumption is that money moving from a business to its owner is a distribution, not a loan. Every documentation factor above becomes a requirement rather than a best practice.
The main danger is recharacterization as a constructive distribution. That happens most often when the borrower can’t actually afford to repay, when payments are sporadic or nonexistent, or when the LLC never enforces missed payments. Courts care more about objective behavior — real payments, real enforcement, genuine collateral — than about what the promissory note says.
Section 7872 imputed interest carries special weight here. A below-AFR loan to a member of a partnership-taxed LLC produces imputed interest income that flows through to members on their K-1s, raising taxable income without extra cash. In a corporate-taxed LLC, the forgone interest becomes a constructive dividend to the shareholder-borrower.6Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
Multi-member LLCs should get written approval from the disinterested members before lending to any single member. Operating agreements commonly restrict interested transactions, and managers who fund personal loans without proper approval can face liability for breach of the duty of loyalty. The fiduciary duties members owe each other make undisclosed self-dealing loans risky even where the operating agreement is silent.
The Hard Stop: LLCs Owned by a Retirement Account
One scenario catches people off guard. If the LLC is owned by a self-directed IRA or Solo 401(k), it cannot lend money to the account holder, the account holder’s spouse, children, parents, or certain business partners.
Under IRC Section 4975, any loan between a retirement plan (or an entity it owns) and a “disqualified person” is a prohibited transaction. The prohibition is absolute. Fair market terms and good intentions don’t matter.10Office 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 stays uncorrected. If it isn’t unwound during the correction period, an additional tax of 100% of the amount involved applies.10Office of the Law Revision Counsel. 26 U.S. Code 4975 – Tax on Prohibited Transactions A prohibited transaction can also disqualify the entire IRA, causing the full account balance to be treated as a distribution in the year of the violation, with income tax on the whole amount plus a 10% early withdrawal penalty if the account holder is under 59½.
For a retirement-account-owned LLC, the rule is simple: lend to unrelated third parties only.
Securing the Loan and Handling Nonpayment
If the loan is secured by the borrower’s property, the LLC needs to perfect its security interest to gain priority over other creditors and protect itself if the borrower files bankruptcy. For personal property (equipment, vehicles, receivables), that generally means filing a UCC-1 financing statement with the secretary of state in the borrower’s state. Filings are effective for five years; miss the continuation and the interest becomes unperfected. For real property, the LLC records a deed of trust or mortgage with the county recorder where the property is located, the same way any mortgage lender would.
Beyond legal priority, collateral supports the argument that the transaction is real debt. A lender that doesn’t bother protecting itself against default looks like a lender that never expected to be repaid.
If the borrower stops paying and the debt becomes uncollectible, the LLC may claim a bad debt deduction. A business bad debt (one created in connection with the LLC’s trade or business) can be deducted in full or in part in the year it becomes worthless. A nonbusiness bad debt can be deducted only when totally worthless and is reported as a short-term capital loss, subject to the annual capital loss limits.11Internal Revenue Service. Topic No. 453, Bad Debt Deduction Either way, the LLC has to show the original transfer was intended as a loan and that reasonable collection efforts were made before writing it off. Walking away without any collection activity undermines the deduction and, retroactively, the loan characterization itself.