Dangers of Circular Business Loans

Circular business loans are alternative finance instruments used to provide business capital and avoid the bureaucracy of banks. A circular business loan is defined as a loan between entities that are controlled by the same person.

The parties involved in a circular business loan can include a business, its subsidiary companies, the business owner and his personal assets such as an IRA or trust. A business owner may choose to loan personal assets to his company in lieu of direct capital investment. The money receives better tax treatment and is returned sooner. If the company goes bankrupt, lenders recover funds before investors.

Although legal, circular business loans are tightly monitored by the Internal Revenue Service and subject to many rules. A circular business loan must be well documented with a note showing payment schedule and interest rate. The borrower must make payments on the loan. If no money is actually moved around, then certain tax advantages are lost.

Circular business loans should not give preferential terms to the lender or borrower. The most common preferential treatments are non-market interest rates, delay of payment and cancellation of debt.

Non-market interest rates can be higher or lower than the market rate. Sometimes the initial payment schedule gets postponed indefinitely, effectively allowing the borrower an interest-free loan. In either case, the IRS may decide that the uncharged interest is actually undeclared income.

A higher than market interest rate may allow the borrower to take excessive interest payment deductions as a way to shelter its revenue. In this case, the IRS would disallow a portion of the interest deduction and would require income tax to be paid on that amount.

Cancellation of debt occurs when the lender simply forgives the loan. If this happens, the lender cannot declare any kind of capital loss or bad debt expense from the circular business loan on its tax return. The borrower must declare the forgiven principal as income and pay tax on it.

Another dangerous circular business loan situation involves companies loaning money back and forth to increase cash and assets on hand. A company might do this if it is looking for additional business capital investment, or trying to show financial strength to a potential customer. Since the actual financial position of either company is not truly changed, the IRS disallows any deductions or expenses stemming from this type of loan, and investors may attempt to hold the company liable for fraud if things go badly.

Another way to pump up a business' strength on paper with circular business loans involves off-balance sheet companies. A subsidiary company loans money back to the parent business. The subsidiary company has no purpose other than to hold the debt of the parent company "off the balance sheet" via the circular business loan. This makes the financial strength of the parent company look much stronger. Enron is the most widely known example of how this strategy can blow up.

If you are thinking of using circular business loans with your businesses, consult an accountant and follow the IRS' directives concerning circular business loans carefully, or you may be on the hook for back taxes, fines, penalties or even jail time.