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? My post last week about a Tax Court case involving a loan to a business (that turned out not to be a loan) got me to thinking about this subject.
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. 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
As we saw in last week's Tax Court case, you can certainly loan money to your business, but make sure the loan is an arms-length transaction that clearly separates you from the business and that puts in writing the expectations from the company - 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 when it is repaid. The repayment on 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 in owners equity (retained earnings in a corporation). You can take out the money at any time without tax consequences, but if you take out gains or get a dividend, you pay capital gains taxes on these payments.
Risks of Each Option
Your loan to your business makes you a creditor, just like the bank or vendors. 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 invest in your business and it goes bankrupt, you probably will not get your money back.
Your decision is yours to make. Whichever you decide, 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. Mixing business and personal funds is a trigger for IRS scrutiny, and you can help yourself and your business by making it clear to anyone who looks how the funds are accounted for.
Disclaimer: This post, and the information on this Guide Site, is intended for general information only. The author is not a CPA, tax attorney, or Enrolled Agent. Consult with your tax professional for information relating to your specific situation.