Do I Have to Charge Interest on a Loan to My Company?

If you lend money to your own company, you generally do have to charge interest, and the rate must be at least the IRS’s Applicable Federal Rate for the month the loan is made. Charging interest on a loan to your own company is what keeps the IRS from treating the arrangement as a disguised way to move money out of the business tax-free. There is one meaningful escape hatch: if the total outstanding balance between you and the company stays at or below $10,000, the interest requirement does not apply, provided tax avoidance is not a principal purpose of the arrangement.¹

Skip the interest on a larger loan and the IRS will impute it for you, meaning you owe tax on interest you never actually received.²

The $10,000 Exception

Section 7872 carves out a de minimis rule for loans between a corporation and a shareholder, and between an employer and an employee. If your aggregate loan balance with the company never exceeds $10,000 on any given day, the below-market loan rules do not apply and you do not have to charge interest.¹

There is a catch that swallows this exception quickly. If a principal purpose of the interest-free arrangement is federal tax avoidance, the safe harbor disappears. A $5,000 interest-free advance to cover a short-term cash gap probably qualifies. A rolling series of $9,500 loans structured to pull profits out without dividend treatment probably does not. The IRS looks at economic reality, not just the dollar amount.

What Rate You Have to Charge

The Applicable Federal Rate is the IRS’s floor for interest on related-party loans, and it is published monthly through Revenue Rulings.³ The rate comes in three tiers keyed to the loan’s maturity, as defined in Section 1274(d) of the Internal Revenue Code:⁴

Short-term: loans with a maturity of three years or less
Mid-term: loans with a maturity over three years but not more than nine years
Long-term: loans with a maturity over nine years

For February 2026, the base AFRs with annual compounding are 3.56% short-term, 3.86% mid-term, and 4.70% long-term.⁵ Because the rates shift each month, check the ruling for the month your loan actually originates. The published tables also give slightly different rates for semiannual, quarterly, and monthly compounding, so your promissory note should state the compounding period and use the matching column.

Demand Loans Versus Term Loans

This is where owners often trip up. Section 7872 treats the two structures very differently.

A term loan has a fixed maturity date written into the note. The AFR is locked in on the day the loan is made and stays the same for the loan’s entire life, no matter how rates move later. Pick short-term, mid-term, or long-term based on the maturity date, and that is your rate.⁶

A demand loan has no set maturity. The lender can call it due at any time. Because there is no fixed term, the applicable rate is the short-term AFR in effect for each period you are calculating forgone interest, and it floats.⁶ Charge 2% on a demand note and you are fine in months when the short-term AFR sits below 2%, but you have imputed interest in any month it rises above. That rolling recalculation is an accounting nuisance. For most owner loans, a term note with a locked-in rate is simpler.

What Happens if You Charge Too Little

When a loan charges less than the AFR, the IRS treats the missing interest as if it were paid anyway, through a two-step fiction. First, the company is deemed to have paid the shortfall to the owner. The owner reports that amount as taxable interest income even though no cash moved.⁷ Second, the owner is deemed to have transferred the same amount back to the company. How that deemed transfer is taxed depends on the relationship.

C-Corporation Loans

The deemed transfer back is typically treated as a contribution to capital or a dividend. The shareholder pays tax on the imputed interest, and the corporation generally cannot deduct the interest it was deemed to pay. That combination is the worst-case result: tax on money you never received and no offsetting deduction for the company.

Employer-Employee Loans

If the owner is also an employee, the deemed transfer back may be recharacterized as compensation. The company treats the imputed amount as wages subject to payroll taxes and gets a compensation deduction, but the owner owes income tax and payroll tax on it.

S-Corporation and Partnership Loans

Imputed interest rules still apply to pass-throughs. The flow-through structure often softens the cash impact because the same owner reports both sides, but the reporting obligations remain, and sloppy compliance can still draw penalties.

A Quick Example

Say you lend your C-Corporation $100,000 for five years at 1% interest when the mid-term AFR is 3.86%. You collect $1,000 in interest that year. The AFR says you should have collected $3,860. The $2,860 gap is imputed interest. You report $2,860 as additional interest income on your personal return, the company is deemed to have paid it, and the deemed transfer back to the company is taxed according to your relationship with the entity. You owe tax on $2,860 you never touched.

Penalties for Not Reporting

Failing to report imputed interest is not just a matter of catching up later. If the omission produces an underpayment, the IRS can assess an accuracy-related penalty of 20% of the underpaid tax under Section 6662.⁸ The penalty applies when the underpayment comes from negligence or a substantial understatement, which the IRS defines as the greater of 10% of the tax due or $5,000. On a sizeable loan, the imputed interest alone can push you across that threshold.

Paperwork That Makes the Loan Hold Up

Getting the rate right is only half the job. The IRS can still recharacterize the whole loan if the paperwork is thin or the parties ignore the terms.

Start with a formal promissory note stating the principal, the interest rate (at or above the AFR), the compounding frequency, a specific maturity date, and a repayment schedule for both principal and interest. For a term loan, the maturity date is what determines which AFR tier applies, so it needs to be definite.

Then actually follow the note. This sounds obvious, but it is where most owner loans fail under audit. Missed payments that go unenforced signal that this was never a real loan. If the company genuinely cannot pay, document the miss and send a written notice, the way a bank would. A pattern of casually skipping payments with no consequences is one of the strongest indicators that the “loan” was really a capital contribution.

The board of directors, or managing members for an LLC, should formally approve the loan through a resolution recorded in the minutes. The resolution should reference the specific terms and authorize an officer to execute the note. That paper trail shows the loan was an arm’s-length transaction evaluated by the company’s decision-makers, not an informal cash shuffle.

For extra protection, the owner can take a security interest in company assets by executing a security agreement and filing a UCC-1 financing statement with the state where the company was formed. Collateral is not required, but it strengthens the case that the transaction is real debt. Filing fees generally run between $10 and $100 depending on the state.

Keep everything together: the board resolution, the signed note, evidence of the fund transfer, payment records, and any correspondence about missed or late payments. If the IRS questions the loan years later, your position depends entirely on what you can pull out of the file.

The Risk of Being Reclassified as Equity

Even with proper interest, the IRS can recast a purported loan as an equity contribution if the whole arrangement looks more like an investment than a debt. Section 385 lists factors the IRS weighs when deciding whether something is really debt or really stock:⁹

Whether there is an unconditional written promise to pay a fixed sum with interest
Whether the loan is subordinated to other creditors, which looks more like equity
The company’s debt-to-equity ratio, since heavy owner-loan funding relative to actual equity is a red flag
Whether the debt can convert into stock
Whether the loans mirror the ownership percentages, suggesting they are really capital contributions

Reclassification is costly. If your loan gets treated as equity, the company loses its interest deduction, and every principal repayment you received is treated as a dividend distribution rather than a tax-free return of capital. The whole economic structure changes retroactively. A company funded almost entirely by owner loans with minimal equity, sometimes called thinly capitalized, is practically inviting a challenge. A reasonable mix of actual equity contributions and properly documented loans is the safest structure.

A Note for S-Corporation Owners

If you own an S-Corporation, lending to the company does more than fill a cash need: it increases your debt basis. That basis matters because you can only deduct S-Corporation losses up to the combined total of your stock basis and your debt basis. A direct loan gives you more room to absorb pass-through losses on your personal return.¹⁰

One point regularly missed: guaranteeing a bank loan to the company does not create debt basis. Only money you personally lend to the corporation counts. If the company borrows from a bank and you sign a personal guarantee, your basis does not increase until you actually make a payment under that guarantee.¹¹ This distinction catches S-Corporation shareholders out, especially when they are trying to deduct pass-through losses that exceed their stock basis.

1
Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates
2
Internal Revenue Service. Memorandum AM 2023-008
3
Internal Revenue Service. Applicable Federal Rates Rulings
4
Office of the Law Revision Counsel. 26 USC 1274 – Determination of Issue Price in the Case of Certain Debt Instruments Issued for Property
5
Internal Revenue Service. Rev. Rul. 2026-3
6
Office of the Law Revision Counsel. 26 US Code 7872 – Treatment of Loans With Below-Market Interest Rates
7
Internal Revenue Service. Topic No. 403, Interest Received
8
Office of the Law Revision Counsel. 26 US Code 6662 – Imposition of Accuracy-Related Penalty on Underpayments
9
Office of the Law Revision Counsel. 26 US Code 385 – Treatment of Certain Interests in Corporations as Stock or Indebtedness
10
Internal Revenue Service. S Corporation Stock and Debt Basis
11
Internal Revenue Service. Instructions for Form 7203