As a new business owner, you will probably need to put money into your business from your personal savings. If you don't need a bank loan, you'll need what is called an "infusion of capital" or a capital contribution to get the business started.
Even if you can get money from friends or family, or from a lender, you will need to put some of your own money into the business. If you are joining a partnership, a capital contribution is usually required. A lender will want to see that you have some of your own collateral (some of your own personal money) as a stake in the business.
But should that money be a loan to your business or an investment? There are tax and ownership implications for each situation.
Making a Loan to your Business
For tax purposes, a loan from you to your business must be an "arms-length" transaction.
An arms-length transaction is a transaction between two parties who are:
- Independent in both a business and personal sense
- Don't have a close relationship with each other, like a family relationship
This kind of transaction assumes that both have equal bargaining power and aren't subject to pressure from each other. There's also an assumption that neither has a fiduciary duty to the other that would create an inequality.
It should be clear that the loan is a binding obligation on the part of the company. Without a contract, the IRS can deny the validity of the loan.
When you receive payments from the business, they are split between principal and interest.
- The interest on the debt is deductible to the business as an expense. It's taxable to you personally as income.
- The principal is not deductible to the business; no matter how the money is used. There's no restriction on how the business can use this income unless that's specifically stated in the loan agreement. The return of principal to you isn't taxable because you already paid the tax on it, in the year you had the income.
Making an Investment in Your Business
The other option for putting money in your business is to invest the money. In this case, the funds go into your owner's equity account (for a sole proprietorship or partnership) or into shareholders' equity (for a corporation).
If you withdraw your contribution, you may have capital gains tax to pay if there is an increase in the price of the shares. If you withdraw additional money in the form of bonuses, dividends, or draw, you will be taxed on these amounts. There is no tax consequence to the business on this investment.
Which Comes First – Debt or Investment?
Both lenders and shareholders have a claim on the assets of a business, in bankruptcy or in other situations. The shareholders' claims come after debts have been paid.
10 Factors to Consider in Making a Contribution to Your Business
In a 2011 Tax Court case, the Court listed several factors it reviewed in considering whether an owner's contribution was a debt or equity. These factors include:
- The labels on the documents: That is, is the document stated as a loan or an investment?
- A maturity date: The presence of a maturity date strongly suggests a loan.
- The source of payment. Is the payment being made in the form of a dividend or a payment on a loan?
- The right of the (supposed) lender to enforce payment: What happens if the loan isn't repaid? Will there be penalties? Can the loan be foreclosed? This should be stated in the loan documents. This language would not be present in a share of stock.
- The lender's right to participate in management applies in both cases. A lender shouldn't be on a business board of directors (conflict of interest). And usually, stockholders do not participate in management as a qualification for buying shares.
- The lender shouldn't have a greater right to collect compared to other creditors. This language would be present in the documents and has to do with both collection policies and bankruptcy of the company.
- The parties' intent: The presence of a document helps with this part.
- The adequacy of the (supposed) borrower's/the company's) capitalization: In other words, is this a reasonable amount? In a partnership, for example, partners should contribute similar amounts; letting someone into a partnership without enough investment could be an issue.
- The borrower's (the company's) ability to obtain loans from outside lenders.
Whichever you decide - loan or investment - it is important for you to designate your contribution as either a loan with a contract or capital investment with proper paperwork so that the tax implications of the transaction are clear and you avoid any problems with the IRS.
Loan vs. Investment: Risks and Benefits to You
Each of these decisions carries risk, especially if the business can't pay you back or pay dividends. Your biggest risk is that you won't get your money back.
Investing is always riskier. There is no guarantee that an investment will continue to be a good bet for the investor, or even that the investor will break even on the investment. Lending is usually safer, particularly if the loan is tied to some asset used as collateral.
What happens if the business can't pay its bills (in a bankruptcy, for example).
- If you loan money to the business, you become a creditor. Depending on whether the loan was secured or unsecured (with collateral from the business, you may or may not be able to get your money back in a bankruptcy proceeding.
- If you have invested money in the business and it goes bankrupt, your investment is entirely at risk and there is little or no possibility of returning those funds to you.
Which option is best also depends on whether the business is just starting or is established:
- if your business is just starting, an investment by you as the owner allows the business to use your money without the obligation to have to pay you back right away.
- If your business is established and has good cash flow and a good credit rating, making a loan arrangement may be better.
Disclaimer: The information in this article is intended to be general and is not tax or legal advice. Before you make a decision on whether to loan money to your business or invest in a business, talk to your tax attorney or other financial and tax professionals.