The Best Way to Put Money Into Your Startup Business
Investing vs. Loaning Money to Your Business
You are starting a business and you need to put some money in the business - call it "seed money" if you want. What is the best way to account for that money? Should it be a loan or an investment?
Even if you don't have to get money from a bank, you will probably need to put money into your business at the beginning. If you are opening a partnership or limited liability company (LLC), in most cases you will need to make a contribution as your share of the business. in this case, you would be making an investment, not a loan.
So, here you are with check in hand and your bookkeeper says, "How do you want to book this? Is it a loan? Or an investment?" There are tax consequences and risks to each course.
Loaning Money to Your Business
You can certainly loan money to your business you become a lender. That means you personally are giving money to the business in the form of a formal loan, with interest. Make sure the loan terms are written so you are an arms-length transaction that clearly separates you from the business and that puts everything in writing - the interest rate on the loan, how the loan will be repaid, and the consequences if it isn't repaid.
The interest on the loan is taxable to you personally when it is repaid. The repayment of the principal is not taxable since you have already paid the taxes on it.
Investing Money in Your Business
If you invest in your business, you are putting money into the business. If your business is not a corporation, you can put money into your business by just writing a check and depositing it in the business bank account. The money should go into an owner's capital account under the classification of owner's equity on the balance sheet. (This process works in a similar way for partnerships, where it's called a distributive share.)
More formally, you can invest in your business by forming a corporation and buying stock in the business. If the business is small and there are only a few stockholders (called a closely held corporation) you can own most of (or all of!) the business.
If your investment isn't in stock, you can take out the money at any time. For example, you can take an owner's draw out of your owner's equity account. If you take money out by selling stock or get a dividend on your stock, you pay capital gains taxes on these payments.
Risks of Each Option
The options of loaning money to your business or investing are wrapped in the concepts of debt and equity. In the first case, you are the creditor and your business is a debtor. In the second case, you own a piece of (or all of!) the business.
Your loan to your business makes you a creditor, just like the bank or others your business owes money to. If the business can't pay its bills, having a loan document will put you in the group of creditors and give you a chance of getting some of your money back in bankruptcy proceedings. Creditors come before investors in the priority list for bankruptcy.
If you invest in your business and it goes into liquidation bankruptcy (Chapter 7), you probably will not get your money back. Creditors (those to whom the business owes money) get paid first.
How to Avoid Tax Issues with Your Contribution
Whether you decide to loan money to your business or make an investment, how you treat this for tax purposes is important. A 2008 Tax Court decision illustrates the issue.
In this case, the business owner claimed he had paid expenses for his business that were not repaid and he wanted to claim the expenses as bad debts. The Tax Court noted in its findings of facts that the owner "did not demand or receive payment for any of the expenses he paid on behalf of his corporation."
The Tax Court also noted that the loan must "arise from debtor-creditor relationships based upon valid and enforceable obligations to pay fixed or determinable amounts of money." In other words, there must be:
- Written paperwork that creates a clear relationship between the business owner (the creditor) and the business (the debtor)
- Description of the amounts loaned
- A clear expectation that repayment is expected, and the terms and conditions of that repayment, and
- And a clear statement of consequences if the debt is not repaid.
Absent these provisions in writing, there is no loan, and the payment of business bills doesn't constitute an obligation on the part of the business to repay the owner.
How the Tax Court Treated the Owner Payments
A tax court found that the owner's payments were capital contributions and not a loan. That is, the owner is investing more money in the business. This investment is not considered business income, and if the owner takes out his or her investment, capital gains must be paid on that withdrawal.
If you want to loan money to your business, make certain there is paperwork in place that establishes the terms of the loan, the repayment obligation, and penalties for non-repayment. Have an attorney prepare the loan agreement so all the required conditions are included. Then, make sure that the company repays the debt or that the consequences of non-repayment are upheld.
If you want to invest in your business, the same applies: make sure you create a paper trail and shareholder documents to prove that you are actually a shareholder, including the value of the shares you are purchasing and their change in value over time.
So, what's the best way to put money into your business?
It depends on your individual tax and financial circumstances and your business type. Whatever you decide,
1. Discuss the options with both your tax professional and your legal advisors,
2. Put the agreement (loan or capital contribution) in writing, and
3. Keep good records of the transaction and make sure it is clear how the money is to be accounted for in the books of the business.
Disclaimer: The content of this article and all content on this Site, is intended for general information only. The author is not a CPA, tax attorney, or Enrolled Agent. Each business situation is specific, tax laws and regulations change and each state has different regulations. Consult with your tax professional for information relating to your specific situation.
Source: Tax Court Memo 2008-14 (in PDF form).