Circular loans are loans made by an entity owned by the entity receiving the loan. For example, Company A owns a subsidiary company B. Company B makes a loan to company A making the loan circular in the sense the assets all belong to the parent company. This article will discuss circular loans in terms of how they are made, why they are made and tax implications regarding the loans.
How a circular loan takes place
Circular loans are similar to check kiting which is a form of check fraud and is punishable by law. The difference between kiting and circular loans however is that third parties are not involved and the intent is more likely to involve tax evasion than check fraud. Moreover, unless the funds do not exist, the circular loans do not constitute a form of kiting especially if the loaned funds are not used to pay expenses incurred from purchases or services received.
Circular loans are quite conceptually simple and the following example illustrates a circular loan. Mac is the sole owner and shareholder of three small businesses called 1, 2 and 3. Each of these businesses perform different functions. Business 1 is a dry cleaning company, business 2 is pawnshop and business 3 is an accounting practice. The owner of the company decides business 1 requires additional funding for an equipment purchase then “applies” for a loan from business 3. Business 3 then approves the loan and transfers the money to business 1.
Reasons why circular loans take place
The reason(s) the shareholder(s) and/or owner(s) of businesses and the businesses themselves may make circular loans vary. Some of these reasons may be legitimate in the sense that one company may have extra liquid assets that can be better used by the second company to create more profitability. In some cases however, the practice of circular lending may be fraudulent or illegal. For example, if the loans are used to disguise money laundering or to create company worth that does not exist, then the circular loans are probably fraudulent or illegal in some way. Below is a list of reasons circular loans may take place.
• Legitimate financing of business operations
• Owner investment of personal assets
• Money laundering
• Generate false asset value
• Tax evasion
Tax implication of circular loans
Circular loans between some types of corporations are not deductible as an expense if certain conditions are met. For example, if an owner of a S Corporation/Small business makes a loan to a company that then makes a loan to another S Corporation and conditions with the loan terms protect the company and the capital provider from loss, then the loan is not tax deductible.
When the same shareholder as above owns multiple S Corporations between which loans occur, the loans are circular in terms of ownership. Moreover, as per a cost basis adjustment with the shareholders ownership of the company, such loans are not deductible as losses if unpaid because the value of loss is transferred rather than lost.
A similar situation arises when the recipient of the loan is also the owner of the company that makes the loan. In this case, the loan is also circular and may be questioned by tax authorities as being non-deductible due to the circularity of the loan.
Summary
Circular loans are a form of lending between separate businesses with the same ownership. The loans are circular in the sense that the net gain or loss is unchanged in terms of the ownership of the funds. Circular loans may be performed for a number reasons that may or may not be legitimate, thus the discovery of circular lending between businesses of shared ownership may be a red flag to banks, financial institutions or minority investors.
A company that lends a circular loan to the business owner or another company owned by the same party may not perform and thus be at greater risk of default on that loan. However, this is not directly related to the circumstances surrounding the loan itself. Circular loans performed for the purpose of reducing taxes is considered illegitimate in some cases as documented within the sources provided within this article.
Sources:
1. http://www.mobar.org/405bc858-3bcc-4faa-96ea-5607d75e5772.aspx http://www.allbusiness.com/personal-finance/individual-taxes-tax-deductions/950077-1.html http://www.bankrate.com/brm/news/chk/20021203b.asp
2. http://www.cpeforum.org/fall2006docs/Partnership%20-%20MSCPA.doc