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.
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.
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.
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.
There are three categories of intercompany loans based on the percentage of ownership the lender gets of the company:
Other intercompany investments can fall outside these categories without losing validity depending on how ownership works between the two companies involved.
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.
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:
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.
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.
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.
Both options also reduce excessive paperwork typically associated with bank loans.
Other reasons are:
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.
Advantages
Disadvantages
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.
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.
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