When a member puts money or property into a newly formed Arizona LLC, one of the most important decisions they face is this: is the money a loan or a capital contribution? The answer determines how the transaction is taxed, who gets paid first if the LLC fails, and whether the IRS will respect the arrangement at all. Getting this wrong — or failing to document it properly — can cost members dearly.

I have formed more than 10,000 Arizona LLCs, and I regularly see members make the same avoidable mistakes with LLC funding: no written documentation, no member resolution, no promissory note, and no guidance to the CPA. This article explains everything you need to know so your LLC's funding is legally sound from day one.

The Two Ways a Member Can Fund an Arizona LLC

When a member contributes money or assets to an LLC, the transaction must be classified as one of two things: a capital contribution or a loan. These are fundamentally different in legal and tax character, and the distinction matters enormously — for taxes, for asset protection, and for what happens when the LLC is sold or dissolves.

Capital Contributions: What They Are and How They Work

What Is a Capital Contribution?

A capital contribution is money or property a member transfers to the LLC in exchange for their ownership interest — or to increase the LLC's available capital after formation. It is not debt. The LLC owes the member nothing in return except their membership interest and whatever future distributions the LLC makes.

The contribution increases the member's capital account — the running ledger of what the member has put in, minus what has been distributed out, adjusted for allocated profits and losses. Capital accounts are critical when the LLC is sold, dissolved, or when members have disputes about their economic rights.

Tax Treatment of a Capital Contribution

• The contribution is not taxable income to the LLC.
• The member receives no deduction for making the contribution.
• The member's tax basis in their LLC interest increases by the amount contributed.
• When the LLC distributes money back, the member recovers their basis tax-free first; amounts above basis are taxable gain.

What Happens in a Liquidation or Dissolution?

This is where capital contributions carry their biggest risk. In a dissolution or bankruptcy, creditors are paid first. Members who made capital contributions are equity holders, not creditors. They stand at the back of the line. If the LLC's assets are exhausted paying creditors, the contributing member may recover nothing.

Member Loans to the LLC: What They Are and How They Work

What Is a Member Loan?

A member loan is a debt transaction. The member lends money (or transfers an asset) to the LLC and the LLC owes that money back, with interest, on defined repayment terms. The lending member becomes a creditor of the LLC, in addition to being an equity owner.

A loan does not increase the member's capital account or change their ownership percentage. It creates a separate liability on the LLC's books — a debt owed to the member, just as if the LLC had borrowed the money from a bank.

Tax Treatment of a Member Loan

• Interest payments the LLC makes to the member are deductible by the LLC as a business expense, reducing taxable income passed through to all members.
• Interest received by the member is ordinary income to the member.
• Repayment of principal is not taxable to the member — they are simply receiving their loan back.
• Unlike a capital contribution, a loan does not increase the member's tax basis in the LLC (though certain multi-member debt allocations can affect outside basis — consult a CPA).

What Happens in a Liquidation or Dissolution?

This is the key advantage of structuring funding as a loan: the lending member stands as a creditor of the LLC. Creditors are paid before equity holders in a liquidation. If the LLC has assets remaining after paying outside creditors, the lending member is repaid their loan balance before any assets are distributed to members as equity. In a struggling LLC, this can mean the difference between recovering your investment and recovering nothing.

Loans vs. Capital Contributions: Pros and Cons

There is no universally correct answer — the right choice depends on the LLC's circumstances, the member's goals, and applicable tax considerations. Here is a balanced comparison.

Capital Contributions

Member Loans

The Promissory Note: Why Every Member Loan Requires One

A member loan must be evidenced by a written, signed promissory note to be respected as genuine debt — by the IRS, by courts, by other creditors, and by any future buyer of the LLC. A handshake agreement, an email, or a QuickBooks entry is not a promissory note.

What the Promissory Note Must Contain

A properly drafted promissory note between a member and the LLC must include:

1. The parties — the member as lender, the LLC as borrower, with full legal names
2. The principal amount of the loan in dollars
3. The interest rate — must be at or above the IRS Applicable Federal Rate (AFR) for the applicable loan term; a 0% interest rate is a red flag that invites IRS scrutiny
4. A fixed repayment schedule — monthly, quarterly, annually, or a balloon payment at maturity; vague language such as "when the LLC can afford it" is not acceptable
5. A maturity date — a specific calendar date by which the loan must be repaid in full
6. Default provisions — what constitutes a default and the lender's remedies
7. Governing law — Arizona
8. Signatures of both the lending member and an authorized manager or member signing on behalf of the LLC

The IRS Applicable Federal Rate (AFR)

The AFR is the minimum interest rate required by the IRS for loans between related parties, including member loans to an LLC. It is published monthly and varies by loan term: short-term (up to 3 years), mid-term (3 to 9 years), and long-term (over 9 years). If the promissory note uses an interest rate below the current AFR, the IRS will impute interest at the AFR rate — meaning the lender must report interest income they never actually received. Your CPA can provide the current AFR before you finalize the note.

Member Resolutions: Required for Both Loans and Capital Contributions

Why a Resolution Is Required

An LLC is a legal entity that is separate from its members. When a member puts money into the LLC — whether as a loan or a capital contribution — the LLC must formally authorize and document that transaction in writing. The vehicle for doing that is a written member resolution, sometimes called a consent of members.

A properly signed member resolution accomplishes five critical things:

• Creates a contemporaneous written record that the transaction was intentionally authorized and properly classified from day one
• Protects the LLC in an IRS audit by demonstrating the classification was deliberate, not an afterthought reconstructed years later
• Protects the lending member's creditor status if a future bankruptcy trustee or opposing creditor challenges whether the loan was genuine
• Provides a clear paper trail in any member dispute or litigation about how funds were treated
• Gives the LLC's CPA or bookkeeper unambiguous instructions on exactly how to book the transaction

What a Resolution for a Capital Contribution Should Contain

• The contributing member's full name
• The dollar amount or a description of the property being contributed
• Confirmation that the transfer is a capital contribution — not a loan
• A statement of whether the contribution changes the contributing member's ownership percentage (and if so, by exactly how much, consistent with the Operating Agreement)
• The date of the transfer
• Signatures of all members

What a Resolution for a Member Loan Should Contain

• The lending member's full name
• The principal amount of the loan
• A reference to the promissory note by its date and key terms (interest rate, maturity date)
• Authorization for the LLC to borrow the funds and execute the promissory note
• Designation of who is authorized to sign the promissory note on behalf of the LLC
• The date of the loan
• Signatures of all members

Why All Members Must Sign

Even if the Operating Agreement authorizes a manager or majority of members to act unilaterally, having every member sign the resolution eliminates future disputes about whether the transaction was properly authorized. In a multi-member LLC, a member who later claims they had no knowledge of — and did not consent to — a loan made by another member can trigger costly litigation. All-member signatures create an airtight record that every member reviewed and agreed to the transaction, its classification, and its terms.

What the LLC Must Tell Its CPA or Bookkeeper

Whether the funding is a loan or a capital contribution, the LLC must give its accounting professional the complete picture immediately. Misclassified transactions discovered during a tax audit or in litigation are expensive to unwind. Here is exactly what to provide:

For a Capital Contribution — Tell the CPA/Bookkeeper:

1. The member's name and the exact date the funds or property were received
2. The dollar amount (for cash) or the agreed fair market value (for property — which the CPA may need to help establish or document)
3. That this is a capital contribution, not a loan — it must be booked to the member's capital account, not to any liability account
4. Whether the contribution changes the member's ownership percentage — the CPA needs this to properly allocate future profits, losses, and distributions
5. A copy of the signed member resolution authorizing the contribution
6. If property (not cash) was contributed: a description of the property, the contributing member's cost basis, and the agreed fair market value — both figures have tax implications the CPA must track and report

For a Member Loan — Tell the CPA/Bookkeeper:

1. The member's name and the date the funds were received by the LLC
2. The principal amount of the loan
3. That this is a loan, not a capital contribution — it must be booked as a liability (e.g., "Loan Payable — [Member Name]"), not to a capital account
4. The interest rate and repayment schedule from the promissory note — the CPA will need to accrue interest expense each accounting period
5. A copy of the signed promissory note
6. A copy of the signed member resolution authorizing the loan
7. The maturity date so the debt can be classified correctly as current (due within 12 months) or long-term on the balance sheet
8. Any collateral pledged by the LLC, which affects financial statement disclosures

Quick Reference: Loans vs. Capital Contributions

The Bottom Line

For most newly formed Arizona LLCs, the right funding structure depends on two primary questions: How important is it to the member to be repaid if the LLC struggles? And how important is simplicity and balance sheet strength? A loan prioritizes the member's recovery; a capital contribution prioritizes clean governance and tax simplicity.

Regardless of which method you choose, the universal rule is this: document everything in writing before the money moves. A member resolution drafted the same day the funds are transferred costs almost nothing. Trying to reconstruct the intent of an undocumented transaction three years later during an IRS audit — or in the middle of a member dispute — is extraordinarily expensive and frequently unsuccessful.

The same discipline applies to your CPA or bookkeeper. Give them the resolution and, if applicable, the promissory note as soon as the transaction occurs. Misclassified transactions that go uncorrected compound over years of tax returns and financial statements. Cleaning them up later — or discovering the misclassification during a sale or audit — is far more painful and costly than getting it right from day one.

Frequently Asked Questions

Can a member make both a capital contribution and a loan to the same LLC?

Yes. A member can fund the LLC through both methods simultaneously or at different times. For example, a member might contribute $50,000 as equity (capital contribution) at formation and later loan the LLC an additional $25,000 when it needs operating capital. Each transaction must be documented separately with its own resolution, and the loan must be backed by its own promissory note.

What happens if a member loan is never repaid?

If the LLC is unable to repay a member loan, the lending member may be able to claim a bad debt deduction on their personal tax return — but only if the loan was bona fide debt supported by a promissory note with genuine repayment terms. An undocumented "loan" that the IRS has already recharacterized as a capital contribution cannot be claimed as a bad debt loss.

Does an Arizona LLC's Operating Agreement need to address capital contributions?

Yes. A well-drafted Arizona LLC Operating Agreement should specify whether members are required to make initial capital contributions, what happens if a member fails to contribute, whether the LLC can require additional contributions in the future, and how contributions affect ownership percentages. Without these provisions, disputes about equity and capital are governed by Arizona's default LLC statutes, which may not reflect what the members intended.

What is the Applicable Federal Rate and where do I find the current rate?

The Applicable Federal Rate (AFR) is the minimum interest rate the IRS requires for loans between related parties. The IRS publishes the AFR monthly in a Revenue Ruling. Your CPA can provide the current rate, or you can find it by searching the IRS website for the current month's AFR Revenue Ruling. The rate varies by loan term: short-term (up to 3 years), mid-term (3 to 9 years), and long-term (over 9 years).

Can the promissory note allow the LLC to defer loan payments?

Yes, the promissory note can include a provision allowing the LLC to defer principal payments (and in some cases interest) during periods of financial hardship, as long as the note still has a defined maturity date and mandatory repayment terms. Deferred interest typically accrues and is added to the principal balance. A CPA should review any deferral provision to confirm it does not inadvertently trigger IRS recharacterization concerns.