Benefits of Circular Business Loans

Circular loans are a form of alternative finance involving entities who are substantially the same person. This might include a particular business, its subsidiary companies or the personal assets of the business owner.

Circular might be chosen over other forms of alternative finance such as receivables financing for a variety of reasons. Among them are:

  • Infusing business capital into a distressed business that wouldn’t qualify for other types of alternative finance
  • Buying a partner out of the business
  • Funding subsidiary businesses with startup funds
  • Investing personal assets into a business

The most obvious benefit of circular loans over other forms of alternative finance is that money stays “in the family”. One entity gets needed funds (possibly at a more favorable interest rate), while the other business gets an investment with a better return than a business bank account. The arrangement is favorable to the business owner because money that might go to a credit card company or bank instead stays in one of the businesses.

Business owners investing personal assets as a circular loan may get a better return on investment than traditional investments. Loaning money, instead of investing it as business capital, allows the owner to take his personal assets out of the company on a set schedule instead of waiting for a dividend. The owner does not have to pay taxes on the return of principal from the circular loan.

Ease of obtaining a circular loan is another benefit. If a subsidiary business cannot meet a bank’s benchmarks for income and transparency, then it would be difficult or impossible to obtain a business loan. A circular loan needs less paperwork and closes more quickly, allowing the borrowing entity to get needed business capital sooner.

Circular loans allow a business owner to spread a smaller pool of business capital among several companies. A formal capital investment to a company forces a business owner to wait for the company to become profitable enough to return the capital. By providing the business capital in the form of circular loans, the capital can be loaned over and over again, with the business repaying the loan bit by bit.

Owners risk running afoul of the Internal Revenue Service if either subsidiary company gets too sweet a deal in a circular loan. Charging an interest rate that is much lower or higher than market rate would unduly benefit one of the subsidiary companies, and may incur a penalty or additional taxable income for one of the parties to the loan. Circular loans from an owner’s personal assets are subject to the same scrutiny for favorable treatment. Tax advisors should be involved in the creation of any circular loan to ensure compliance with tax laws.

The relaxed financial and paperwork requirements of circular loans also adds risk of default, particularly if the circular loan is to a struggling company, or if there is a lack of paperwork to substantiate the loan. It is important for all businesses to document their loans, and to treat repayment schedules as seriously as if the money had come from a bank.