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?
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.
Lending Money to Your Business
If you are opening a partnership or limited liability company (LLC), in most cases you will need to make an owner contribution as your share of the business capital. In this case, you would be making an investment, not a loan.
When you lend money to your business you become a lender. You'll need to write up a business loan agreement. Make sure the loan terms are written so you have an arms-length transaction that clearly separates you from the business and that puts everything in writing, including the interest rate on the loan, how the loan will be repaid, and the consequences if it isn't repaid.
This article has information about how to put together a business loan agreement, including typical sections. Get help from an attorney to write your loan agreement, so you don't miss anything important.
The interest on the loan is taxable to you personally when it is repaid. Your business should send you a Form 1099-INT after the end of the year showing the total interest you received during that year. Your business repayment of the principal is not taxable since you have already paid the taxes on it.
Investing Money in Your Business
If you put money into shares of stock or ownership shares in your business, you are an investor. 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 your individual 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 becoming a shareholder in the business. If the business is small and there are only a few shareholders (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. Your draw isn't taxable to you when you take it out because you have already paid tax on your business net income.
If you take money out by selling stock or get a dividend on your stock, you pay capital gains taxes on these payments. The business must give you a Form 1099-DIV showing the total amount of your dividends for the year.
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 case of debt (lending), you are the creditor and your business is a debtor. In the second case, with ownership shares, you own a piece of the business. You have more risk with equity investing than with lending money.
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. If you are a shareholder, you are last in line in a bankruptcy, and there may be nothing left for you.
How to Avoid Tax Issues With Your Contribution
Whether you decide to lend money to your business or make an investment, consider how this will affect your personal taxes. 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 meet these requirements:
- 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 of repayment and the terms and conditions of that repayment
- And a clear statement of what happens if the debt is not repaid
The tax court found that the owner's payments were capital contributions and not a loan. That is, they said the owner was 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 tax must be paid on that withdrawal.
Before You Make that Loan or Investment to Your Business
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 by the lender (you).
If you want to invest in your business, the same applies: make sure you create 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.
What's the Best Way to Put Money Into Your Business?
It depends on your individual tax and financial circumstances and your business type.
Before You Put Money into Your Business
Disclaimer: The content of this article 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.