Intercompany loans: The pros and cons for a startup

Founders quickly become familiar with applying for and receiving business loans to balance their cash flow or make expansions. However, intercompany investments have different standards for lenders and borrowers and require having a parent company or subsidiary.

There are benefits to using this method of loan-borrowing, but it’s essential to understand all the details surrounding intercompany loans before jumping in. Below, we’ll go over what makes these loans different and how businesses can use them. 

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What is an intercompany loan?

An intercompany loan is established between two related companies, typically with the subsidiary receiving money from the parent company. Loans under this category operate in the same fashion as traditional loans. 

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Intercompany transactions have a fixed interest based on the current market rate with a loan term agreement from one to five years. Rarely can companies financially benefit from a long-term internal loan, but it is an option. 

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Two unrelated companies can’t exchange loans. The borrower or lender is required to have ownership over the other company. Some business owners open a parent company to gain funding and then open a subsidiary for operational purposes.

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Types of intercompany investments

There are three categories of intercompany loans based on the percentage of ownership the lender gets of the company: 

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• Minority Passive: Less than 20% ownership

• Minority Active: 20%-50% ownership

• Controlling Interest: Over 50% ownership

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Other intercompany investments can fall outside these categories without losing validity depending on how ownership works between the two companies involved.

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Are intercompany loans considered debt?

Intercompany lending is considered debt in the same way as a traditional loan. The borrower is under a legal obligation to pay the issuer. Interest is deducted during tax time from each recorded loan payment. 

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The IRS recently augmented tax codes related to intercompany financing and the deductions on interest. Under new 538 regulations, both companies participating in an intercompany loan have to meet the following guidelines: 

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• The borrower is financially able to repay the loan.

• The borrower agrees unconditionally to repay the loan.

• Borrower and issuer have proof of a debt-creditor relationship (payments made, for example).

• The loan's interest rates must match the current market and follow the arm’s length price. 

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Not following the rules mentioned above or lack of proper documentation can trigger the IRS to change the loan’s classification to “stock trade,” eliminating interest as tax deductible. Missteps in documentation and IRS requirements lead to complicated tax issues for the parent company and its subsidiaries or affiliates. 

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Why companies engage in intercompany lending

In most cases, companies use this type of funding as a quick cash flow problem solver. For example, a subsidiary can fix financial issues or launch a new product without straining costs by borrowing from a parent company. 

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A parent company can also alleviate this stress by investing via a loan. The income earned is put towards the loan, and the issuer takes their cut from owning the subsidiary as net income grows. 

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Both options also reduce excessive paperwork typically associated with bank loans.

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Other reasons are:

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• Purchasing fixed assets for depreciation tax deductions.

• If a subsidiary struggles to raise funding, the parent company can step in to keep production and operations on schedule. 

• Limit spread banks earn

• Alternative for capital investments, fundraising, or outsourced loans.

• Improve the financial standing of the borrowing company.

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Advantages and disadvantages of intercompany lending

There are benefits and risks associated with intercompany loans. Business decisions as a whole come with both, but intercompany lending affects two separate companies instead of one. 

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Advantages

• No need to fill out loan applications with multiple banks or agree to high-interest rates.

• A quick process is typically done through third-party software.

• Investment capital raised by the parent company can be given directly to the subsidiary.

• Banks or outsourced companies take a cut of the loan.

Disadvantages

• Intercompany settlements: Despite the relationship between the two companies, one party may question the interest recordings, a payment could be logged as missing, or different accounting periods can cause problems with proper reconciliation.

• Tax issues: The interest rate and payments must be recorded, and each is subjected to individual tax regulations. 

• Inability to pay: If the subsidiary or borrower takes a brutal financial hit, the cash flow problem can overflow to the issuer. This can negatively impact the financial standing of both companies and affect overall credit ratings, which can make outsourced borrowing harder in the future.

• Broken terms and conditions: If a borrower does not follow legal obligations, this can trigger an audit from the IRS, cause the issuer financial strain, or require a legal battle between the two companies.

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Tips for intercompany loans

If you’ve decided on an intercompany loan, you can do a few things to reduce problems associated with the transfer of funds. These actions aren’t a guarantee there won’t be bumps in the road, but preparation is key to limiting the damage.

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• Define roles: Anyone involved in transferring and receiving intercompany funding should have a clear and defined job with specific responsibilities to avoid wire-crossing. 

• Proper software: Implement time-saving software that seamlessly integrates funds with an accurate reflection of different metrics. This is important when accounting periods do not line up between companies. 

• Cash management: This loan is most likely for a specific reason. Ensure you and your team have a plan and know where the money is going.

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Managing your finances with Zeni

As a Zeni client, you’ll have an entire finance team dedicated to handling your books. And we grow with your company. You can add new services as you need them or change packages if you want an overhaul of bookkeeping services.