I am starting a business and I need to put money in my business. Should I loan the money to my business or invest the money in my business?
As a new business owner, you will probably need to put money into your business from your personal savings. Even 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. But should that money be a loan to your business or an investment? There are tax implications for each situation.
Making a Loan to your Business
If you want to loan money to your business, you should have your attorney draw up paperwork to define the terms of the loan, including repayment and consequences for non-repayment of the loan. It should be clear that the loan is a binding obligation on the part of the company. As a recent Tax Court case notes, the absence of such paperwork negates the loan. For tax purposes, the loan is an "arms length" transaction, being treated like any other debt. The interest on the debt is deductible to the corporation, and taxable to you personally. The principal is not deductible to the business unless it uses the funds to purchase capital assets (which qualify for depreciation deductions.)The return of principle is not taxable to you, since the loan was after-tax money.
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 owners equity account (for a sole proprietorship or partnership) or into retained earnings (for a corporation). If you withdraw your contribution, there is no tax consequence to you. 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, except in their use of the funds to purchase depreciable assets.
How the Tax Court Views Owner Contributions to a Business
In a recent (2011) Tax Court case (Ramig v. Comm. T.C. Memo 2011-147), the Court listed 10 factors it reviewed in considering whether an owner contribution was a debt or equity:
- the labels on the documents
- a maturity date
- the source of payment
- the right of the (supposed) lender to enforce payment
- the lender's right to participate in management
- the lender's right to collect compared to the regular corporate creditors
- the parties' intent
- the adequacy of the (supposed) borrower's (the company's) capitalization
- whether shareholder' advances to the corporation are in the same proportion as their equity ownership in the corporation
- the payment of interest out of only "dividend money," and
- the borrower's (the company's) ability to obtain loans from outside lenders.
In any case, it is important for you to designate your contribution as either a loan (with the requisite paperwork) or capital investment, so that the tax implications of the transaction are clear and you avoid any problems with the IRS.
Each of these decisions carries risk. If you loan the money to the business and the business declares bankruptcy, you become a creditor and you may or may not be able to get your money back from a liquidation. On the other hand, in the case of a bankruptcy the owner's investment is entirely at risk and there is little or no possibility for returning those funds to you.
This article, and the information on this Guide Site, is intended for general information only; the discussion is over-simplified for the purpose of explanation. The author is not a CPA, tax attorney, or Enrolled Agent. Consult with your tax professional for information relating to your specific situation.