How to document related party transactions: founder loans, intercompany transfers, board approvals

Understanding Related Party Transaction Documentation

The founder loan. It often starts as a simple, necessary act to make payroll or cover an unexpected expense. You transfer personal funds to the company's bank account, log it in a spreadsheet, and move on. The problem is that to an auditor, investor, or tax authority, this simple act is a "related party transaction" that requires specific documentation to avoid serious complications. Failing to get this right can lead to audit delays, tax penalties, and difficult questions from investors about your company's financial governance.

This guide isn't about complex accounting theory; it's about building a defensible financial history that supports your startup's growth. We will cover how to ensure every dollar is clearly and correctly accounted for, whether it comes from a customer or your own pocket. For a complete overview of audit readiness, see the Audit Preparation hub for core steps and documentation.

Foundational Concepts for Related Party Transactions

To navigate this area, a few core concepts are essential. First, you need to understand what auditors and regulators are looking for. Officially, a related party transaction is a business deal between a company and a person or entity that can influence it, including founders, close family, senior management, and other controlled companies.

This definition covers a wide range of activities beyond simple loans. Common related party transaction examples include:

• A founder lending personal money to the company.
• The company paying for services from another business owned by a founder or a close family member.
• The company leasing office space from a property owned by a key executive.
• A parent company covering operational costs for a new subsidiary.

The guiding light for evaluating these deals is a simple but critical test. The "Arm's-Length Principle" is the core concept auditors test to ensure a transaction was made on fair market terms. This means the deal should look the same as it would if the company had made it with a completely independent third party. Was the interest rate on the loan fair? Was the management fee reasonable? Finally, remember that proper reporting is not optional. Compliance with UK and US GAAP disclosure rules is required for related party transactions. In the UK, this is governed by FRS 102 on related party disclosures.

How to Document Founder Loans for a Smooth Audit

Founder loans are the most frequent related party transaction in early-stage startups and a primary focus during any financial review. The key question founders ask is: I lent the company money, what paperwork do I actually need? Without it, auditors may reclassify the loan as a capital contribution, which can dilute ownership, or even as income, creating a tax liability. This makes documenting related party loans a critical part of your startup audit requirements. You can find more statutory reporting context in the UK startup audit checklist.

The goal is to create a clear paper trail that proves the transaction was a legitimate loan from the start. Consider a common scenario: a US-based SaaS startup needs $40,000 to bridge a gap before a customer payment arrives. The founder transfers the funds. To document this correctly, you must create a promissory note and secure board approval.

1. Create a Promissory Note

This does not need to be a 20-page legal document, but it must contain the essential clauses that define the loan's terms. A clear promissory note is your primary evidence.

• Parties: Clearly identify the lender (the founder) and the borrower (the company).
• Principal Amount: State the exact amount of the loan (e.g., $40,000).
• Interest Rate: Specify the interest rate. To satisfy the arm's-length principle, the rate must be defensible. As a rule, a defensible interest rate for a founder loan can be based on the IRS Applicable Federal Rate (AFR). This provides an objective, third-party benchmark that is difficult for auditors to challenge.
• Repayment Schedule: Outline when and how the loan will be repaid (e.g., in a lump sum on the maturity date or in monthly installments).
• Maturity Date: The date by which the loan must be fully repaid.
• Board Approval: Reference the board resolution or written consent that approved the loan, including the date of approval.

2. Secure and Minute Board Approval

Every related party transaction must be approved by the company's board of directors. This is non-negotiable. The approval should be formally recorded in the board minutes or via a unanimous written consent. This step demonstrates proper corporate governance and confirms that the company, as a separate legal entity, formally accepted the loan and its terms. For auditors, this approval is one of the strongest pieces of evidence that the transaction was transparent and authorized.

3. Record the Loan Correctly in Your Accounting System

Once the note is signed and approved, the final step is recording it correctly in your accounting system. In software like QuickBooks, this should be booked to a liability account like "Loan from Shareholder" or "Note Payable - Founder." It should never be categorized as uncategorized income or an equity injection. This ensures the transaction is properly reflected on the balance sheet and aligns with the legal documentation, providing a complete picture for any audit checklist for startups.

Managing Inter-Company Transfers and Reporting

As startups scale, especially across borders, inter-company transfers become the next major hurdle in documenting related party loans and services. A scenario we repeatedly see is a US parent company covering initial operating costs, like salaries or rent, for its new UK subsidiary. Without proper documentation, this creates a messy accounting situation that can trigger tax issues in both countries. The question becomes how to handle intercompany transfer reporting correctly.

The solution is a formal Inter-Company Agreement. This document acts as the master guide for transactions between the entities. It should specify what services are being provided (e.g., management, engineering, marketing support) and how the providing entity will be compensated. This prevents tax authorities from assuming the support was a gift or an undocumented capital contribution, which could lead to penalties.

Establishing a Transfer Pricing Policy

Compensation between related entities is managed through a transfer pricing policy. The goal is to establish an arm's-length price for the services or goods exchanged. While complex methodologies exist, what founders find actually works for most early-stage service arrangements is a straightforward approach. You can read the official OECD transfer pricing guidelines, but a simple method is often sufficient. A common defensible transfer pricing method for services is 'cost-plus,' using a small markup (e.g., 5-10%).

Here’s a simple cost-plus calculation example for intercompany transfer reporting:

• Cost Base: The UK entity's monthly salaries and payroll taxes paid by the US parent total $100,000.
• Markup: The agreed-upon markup in the Inter-Company Agreement is 8%.
• Charge Calculation: $100,000 (Cost) + ($100,000 * 8%) = $108,000.

This $108,000 charge is then formally invoiced from the US parent to the UK subsidiary. In the accounting systems, the US company (using QuickBooks) records an inter-company receivable, while the UK company (using Xero) records an inter-company payable. This creates a clean, auditable trail that substantiates the expenses in the UK and the corresponding revenue or cost reimbursement in the US, fulfilling financial statement disclosures requirements.

A Pragmatic Framework: When to Formalize Documentation

The reality for most Pre-seed to Series B startups is more pragmatic: you don’t need an extensive transfer pricing study for a small, one-time loan. The level of required documentation depends on the transaction's size, frequency, and complexity, a concept known as materiality. For a three-person startup, the key is to do just enough to build a solid foundation without over-engineering it.

At the earliest stages, simplicity rules. The effort should match the risk. For instance, Materiality Threshold Example (Pre-Seed): For a founder loan under $25k, a simple promissory note is likely sufficient. This, combined with a board resolution recorded in the minutes, provides the necessary evidence of the transaction's intent and terms. The effort is minimal, but it establishes good governance from day one and satisfies early-stage startup audit requirements.

As your startup grows and raises institutional funding, the bar gets higher. Transactions become larger and more frequent, attracting greater scrutiny from investors and auditors. At this point, informal agreements are no longer adequate. For example, Materiality Threshold Example (Series A+): A recurring $50,000/month management fee requires a formal agreement and transfer pricing policy. A recurring, high-value transaction like this has a significant impact on each entity's financial statements. Without a formal policy, auditors could challenge the expense allocation, potentially leading to adjustments that affect financial covenants or tax liabilities.

A simple decision framework can help you decide how much effort is needed:

• If the transaction is a one-off and under ~$25,000: A simple promissory note or one-page agreement, plus board minutes, are generally sufficient.
• If the transaction is recurring, involves cross-border entities, or is for a material amount (e.g., over $50,000): A formal, multi-page agreement reviewed by a lawyer is necessary. For inter-company services, a supporting transfer pricing policy documenting your methodology (like cost-plus) is also required.

Actionable Steps for Watertight Documentation

Avoiding future audit headaches from related party transactions comes down to establishing simple, consistent processes today. You don't need a full-time CFO or enterprise software to get this right. The focus should be on creating a clear, contemporaneous record of what happened and why.

1. Create a Central Log: Maintain a simple spreadsheet of all related party activity. For each transaction, record the date, parties involved, amount, a brief description, and a link to where the supporting documentation (e.g., the promissory note) is saved. This becomes your single source of truth during year-end closing or an audit.
2. Use Standard Templates: Work with your legal counsel to create basic templates for common transactions like founder loans and inter-company service agreements. Having these on hand saves time, ensures consistency, and reduces legal costs for each new transaction.
3. Make Board Approvals Routine: Every related party transaction, no matter how small, should be approved via a board resolution or unanimous written consent. Make this a standard agenda item for board meetings. This is one of the strongest pieces of evidence to prove the transaction was known and authorized by the company's governance body, which is a key part of any audit of working papers.
4. Conduct Annual Reviews: Schedule a review of your related party transaction log with your accountant at least annually, before closing the books. This proactive step helps identify any documentation gaps early and ensures all necessary financial statement disclosures are prepared. This makes any future audit or due diligence process significantly smoother.

By implementing these practical steps, you build a robust system for managing related party transactions that will satisfy auditors, investors, and regulators as your company scales. For broader steps and documents, see the Audit Preparation hub.

Frequently Asked Questions

Q: What is the "arm's-length principle" in simple terms?
A: The arm's-length principle means that the terms of a transaction between related parties must be the same as if they were two independent, unrelated parties. For a founder loan, this means charging a fair market interest rate, not an artificially low or high one.

Q: Can I charge 0% interest on a founder loan?
A: It is generally not advisable. Tax authorities like the IRS can "impute" interest on a zero-interest loan, creating a taxable income event for you and the company. Using a benchmark like the IRS Applicable Federal Rate (AFR) is the safest approach to comply with founder loan disclosure rules.

Q: Do I need a lawyer for a simple founder loan promissory note?
A: While templates are available, having a lawyer draft or review your first promissory note is a wise investment. They can create a reusable template that ensures all necessary legal clauses are included, protecting both you and the company. For very small, simple loans, a standard template may suffice.

Q: How do I handle documenting related party loans if the money was already transferred?
A: If you have already transferred funds without paperwork, you should document the transaction retroactively as soon as possible. Draft a promissory note and have the board approve it with a resolution that acknowledges the date the funds were originally received. The key is to rectify the oversight before an audit begins.