When a partner lends money to their own partnership, the tax treatment of the partner loan to the partnership follows the rules for genuine debt: the partnership deducts the interest it pays, the lending partner reports that interest as ordinary income, principal repayments come back tax-free up to basis, and the loan principal increases the lending partner’s outside basis dollar-for-dollar under Section 752. Every one of those results depends on the arrangement being respected as a real debtor-creditor relationship rather than a disguised capital contribution.
Loan or Capital Contribution
The label on the paperwork doesn’t control. A loan creates a fixed obligation to repay; a capital contribution buys a larger equity stake and a share of future profits and losses. If the IRS accepts the transaction as debt, principal comes back untaxed up to basis and the partnership deducts the interest. Recharacterize the same transfer as equity and the picture flips: the partnership loses its interest deduction, the interest payments already deducted get treated as non-deductible distributions, and the “principal” the partner thought was coming back tax-free is taxed under the partnership distribution rules.
Courts and the IRS weigh several factors when deciding which side of the line a transaction falls on. They look for a fixed maturity date, a commercially reasonable interest rate, a binding repayment schedule, and realistic capacity in the partnership to actually repay. Creditor protections such as collateral and priority over other creditors help. A transaction that fails several of these factors is exposed to reclassification even if the document is titled “Promissory Note.”
Documenting the Loan So It Holds Up
Start with a written promissory note or loan agreement signed by the partner as creditor and by the partnership. It should state the principal, the interest rate, a repayment schedule with specific dates, and a maturity date. Open-ended or vague terms are what draw scrutiny.
Setting the Interest Rate
The rate should match what an unrelated lender would charge given the partnership’s credit profile. A rate that is too low pulls the loan into Section 7872, which treats below-market loans as though the lender received interest at the applicable federal rate (AFR) even when no cash interest was paid.1Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates The AFR that applies depends on the loan term: short-term for three years or less, mid-term for three to nine years, long-term beyond nine years. When Section 7872 applies, the partner has to report “forgone interest” as income even though no cash changed hands. Charging at or above the AFR removes the issue.
Reporting on the Partnership Return
The partnership has to carry the loan as a liability, separate from partner capital accounts. On Form 1065, the balance goes on Schedule L, Line 19a, “Loans from partners or persons related to partners.”2Internal Revenue Service. Instructions for Form 1065 (2025) If the partnership pays $10 or more in interest during the year, it issues Form 1099-INT to the lending partner.3Internal Revenue Service. Instructions for Forms 1099-INT and 1099-OID (01/2024) The loan should also show up on the lending partner’s Schedule K-1 at Item K1, in the recourse liability column, because that number feeds directly into the partner’s outside basis.4Internal Revenue Service. Partners Instructions for Schedule K-1 (Form 1065) (2025)
Collateral is not required, but perfecting a security interest through a UCC-1 filing reinforces the argument that a genuine debtor-creditor relationship exists and gives the partner priority over later creditors.
How the Interest Is Taxed
When the loan is respected, the partnership deducts the interest as a business expense on Form 1065, and the lending partner reports it as ordinary interest income. Because that income belongs to the partner in their capacity as a creditor rather than as a partner, it lands on Schedule B of Form 1040 instead of flowing through the K-1 income allocations.5eCFR. 26 CFR 1.707-1 – Transactions Between Partner and Partnership
The Section 267 Matching Rule
A partner and their partnership are related parties, so Section 267 controls the timing of the deduction. If the partnership is on the accrual method and the lending partner is on the cash method, the partnership can’t deduct the interest until the partner actually receives it and reports it as income.6Office of the Law Revision Counsel. 26 USC 267 – Losses, Expenses, and Interest With Respect to Transactions Between Related Taxpayers An accrual-basis partnership that books interest in December but pays it in February can’t take the deduction until the following tax year. If both sides use the same accounting method, the rule has no practical effect.
Not a Guaranteed Payment
Loan interest isn’t a guaranteed payment under Section 707(c). Guaranteed payments compensate a partner for services or the use of capital, are reported in Box 4 of the K-1,7Internal Revenue Service. Schedule K-1 (Form 1065) 2025 and are generally subject to self-employment tax when paid for services. Loan interest is paid to the partner as an outside creditor and is not subject to self-employment tax.8Internal Revenue Service. Topic No. 554, Self-Employment Tax
Net Investment Income Tax
The 3.8% Net Investment Income Tax reaches the partner’s interest income if their modified adjusted gross income exceeds $200,000 (single) or $250,000 (married filing jointly).9Office of the Law Revision Counsel. 26 USC 1411 – Imposition of Tax Interest is generally net investment income, but interest tied to an active trade or business in which the partner materially participates falls outside the NIIT.10Internal Revenue Service. Topic No. 559, Net Investment Income Tax A passive investor lending to their partnership will usually owe the NIIT on top of regular income tax on the interest.
What the Loan Does to Outside Basis
This is where partner loans do their most useful work. Section 752(a) treats any increase in a partner’s share of partnership liabilities as a cash contribution, which lifts the partner’s outside basis.11Office of the Law Revision Counsel. 26 USC 752 – Treatment of Certain Liabilities Outside basis governs how much of a partner’s share of partnership losses they can actually deduct, since Section 704(d) caps loss deductions at the partner’s adjusted basis.12Office of the Law Revision Counsel. 26 USC 704 – Partners Distributive Share
A partner who lends $200,000 to the partnership picks up $200,000 of additional basis. If their allocable share of losses that year is $180,000, the loan basis absorbs it and the full loss becomes deductible. Without the loan, those losses could be suspended until basis appeared from somewhere else.
The Full Loan Goes to the Lending Partner
Regulation 1.752-2 allocates a recourse liability to the partner who bears the economic risk of loss. When the lender is a partner, paragraph (c) of the regulation puts the entire economic risk on that partner: if the partnership can’t repay, the lending partner absorbs the loss as the unpaid creditor.13eCFR. 26 CFR 1.752-2 – Partners Share of Recourse Liabilities The whole principal is allocated to that partner for basis purposes, regardless of their profit-sharing percentage. Third-party debt behaves differently: non-recourse loans from outside lenders are generally split among partners along profit-sharing ratios, so no single partner captures the full basis benefit.
When the partnership repays principal, the process runs in reverse. Section 752(b) treats a decrease in a partner’s share of liabilities as a cash distribution, which reduces basis and can trigger gain if it exceeds remaining basis.11Office of the Law Revision Counsel. 26 USC 752 – Treatment of Certain Liabilities
The Section 465 At-Risk Wrinkle
Basis alone isn’t enough to deduct losses; the at-risk rules under Section 465 impose a second cap. Amounts borrowed from someone with an interest in the activity (other than as a creditor) are generally excluded from the at-risk amount. Section 465(b)(3)(B)(i) carves out an exception for interests held purely as a creditor.14Office of the Law Revision Counsel. 26 USC 465 – Deductions Limited to Amount at Risk The lending partner is both an owner and a creditor, and the at-risk rules apply a 10% ownership threshold when testing related-party status under Sections 267(b) and 707(b)(1). If the lending partner owns more than 10% and the creditor exception doesn’t apply, the borrowed funds may not count as at-risk for the other partners, even though the lending partner’s own at-risk amount is generally unaffected because they put up the cash. The result depends heavily on the facts, and getting it wrong can suspend losses the partners assumed they could deduct.
Self-Charged Interest for Passive Partners
A partner who holds a passive interest and lends to the partnership runs into a mismatch: the partnership treats the interest as a passive deduction, but the partner reports the interest as portfolio income, which can’t offset passive losses. Regulation 1.469-7 lets the lending partner recharacterize a portion of that interest income as passive activity income so it lines up with their share of the partnership’s passive interest deduction.15eCFR. 26 CFR 1.469-7 – Treatment of Self-Charged Items of Interest Income and Deduction The recharacterization is limited by an “applicable percentage” tied to the partner’s share of the deduction. Partners who materially participate don’t need the rule, because their share of the interest deduction is already nonpassive. It matters mostly for limited partners and investors.
The Section 163(j) Cap on Business Interest
Since 2018, Section 163(j) has capped a partnership’s business interest deduction at business interest income plus 30% of adjusted taxable income.16eCFR. 26 CFR 1.163(j)-2 – Deduction for Business Interest Expense Limited Interest on a partner loan counts as business interest subject to the cap. Partnerships with average annual gross receipts of $32 million or less over the prior three years fall inside the small business exemption for 2026 and can skip the limit. Above that threshold, the calculation happens at the entity level, and any disallowed interest is carried forward and allocated to partners, who can use it only when the partnership generates enough ATI in a later year.17eCFR. 26 CFR 1.163(j)-6 – Application of the Section 163(j) Limitation to Partnerships and Subchapter S Corporations A well-documented, market-rate partner loan can still produce a deduction the partnership can’t immediately use.
If the Loan Is Forgiven or Defaults
Forgiveness produces cancellation-of-debt income to the partnership equal to the unpaid principal. Under Section 108(d)(6), the COD exclusions (insolvency, bankruptcy, and the other carve-outs) are tested at the partner level, not the partnership level.18Office of the Law Revision Counsel. 26 USC 108 – Income From Discharge of Indebtedness Each partner takes their allocable share of the COD income and applies any exclusion on their own return.
The basis effects compound the tax. When the loan disappears, the lending partner’s share of partnership liabilities drops to zero, and Section 752(b) treats that reduction as a cash distribution. Any excess over remaining outside basis is taxable gain.11Office of the Law Revision Counsel. 26 USC 752 – Treatment of Certain Liabilities The forgiveness itself may be recharacterized as a capital contribution from the lending partner, which raises equity but ends the creditor relationship and the tax benefits that came with it.
Related-party rules add a further trap. Under Section 108(e)(4), if a related party acquires the partnership’s debt, the acquisition can be treated as though the partnership itself discharged the obligation, triggering COD income even though no one formally forgave anything.18Office of the Law Revision Counsel. 26 USC 108 – Income From Discharge of Indebtedness Partners who are family members or entities under common control need to move carefully when restructuring partnership debt among themselves.