You’re starting a new business, and you have to invest some money. Call it “seed” money if you like. What’s the best way of accounting for this money?
You have a check in your hand, and the bookkeeper asks you “How would you like to record this?” Is this a loan or an investment? “Or is it an investment?” Each course has its own tax implications and associated risks.
You can borrow money to finance your business
In most cases, if you’re opening a limited liability company or partnership, you will be required to pay an owner contributions for your share of business capital. This is an investment and not a loan. 1
You become a financier when you lend money to a business. You will need to create a loan agreement. You should ensure that the loan agreement is written in a way that you can have an arm’s-length transaction, which clearly separates you and the business. Also, make sure that everything is put into writing. This includes the interest rate, the repayment terms, and any consequences that may arise if the loan was not repaid.
Note:
This article contains information on how to create a Business Loan Agreement. It also includes typical sections. You can get help from an lawyer to draft your loan agreement so that you don’t forget anything.
You are liable for the interest when you repay your loan. After the end of each year, your business will send you a form 1099-INT showing you the total interest that you received. The principal that you repay to your business is not taxed because you already paid taxes on it. 1
Investing in Your Business
You are an investor if you invest money in shares of stock, or ownership shares for your business. You can deposit money in your business if it is not a corporation by writing a check. The money will be deposited into your capital accounts and classified as owner’s equity in the balance sheets. This process is similar for partnerships where the distributive shares are used.
Formally, you can invest by forming a company and becoming a shareholder. You can be the majority shareholder of a small business with only a handful of shareholders. If the business is small and there are only a few shareholders (called a a data-component=”link” data-ordinal=”2″ data source=”inlineLink”/data type=”internalLink”), you can own most of (or all!)
You can withdraw the money from your owner’s equity account at any time if it is not in stock. You can, for example, take an Owner’s Draw out of your owner equity account. You won’t be taxed on the draw because you already paid taxes on your net profit.
Capital gains tax is due if you sell stock or receive a dividend. The business is required to give you a 1099-DIV indicating the total amount of dividends received for the year. 3
The Risks of Each Option
equity and are concepts that describe the options for investing or lending money to your company. You are the lender in the case of lending, and your business is the debtor. With ownership shares in the second scenario, you are a part owner of the company. With equity investment, you are more at risk than if you were to lend money.
You can get some of your money repaid if the business is unable to pay its bills. You may not have anything left if you’re a shareholder.
What to do if you want to avoid tax issues with your contribution
Consider how your decisions will impact your taxes, whether you are considering a loan to your business or an investment. The issue is illustrated by a 2008 Tax Court ruling.
In this case, a business owner claimed that he paid expenses to his business which were never repaid. He wanted to claim these expenses as bad loans. In its findings of fact, the Tax Court stated that the owner had “not demanded or received payment for any expenses he paid in behalf of his corporate.”
The Tax Court noted that the loan also must meet these conditions:
- Written documentationthat establishes a relationship between the owner of the business (the creditor), and the business (the debtor).
- The amount of the loan
- The terms and conditions for repayment as well as the expectation of repayment
- What happens if you don’t pay the debt?
The tax court determined that the owner paid capital contributions, and not a debt. They said that the business owner was investing in the company. This investment does not count as business income. If the owner withdraws his or her investment, Capital Gains Tax will be due.
Consider These Things Before Making a Loan or Investment in Your Business
Make sure you have the appropriate paperwork if you are planning to lend money to your company. This will include the loan terms, repayment obligations, and penalties if the loan is not repaid. An attorney can prepare the loan agreement to ensure that all conditions are met. Ensure that the company pays the debt, or that you (the lender) enforces the consequences if it does not.
You should also create shareholderdocuments if you plan to invest in the business. These documents will prove to you that you own the shares and show their value as well as the change in value.
What is the best way to invest money in your business?
Your tax situation, financial status and business type will determine the answer.
Don’t invest in your business until you are ready
- Talk to your tax advisor and your legal advisers about the options available.
- The agreement (loan, or capital contributions) should be in writing.
- Be sure to keep good records and that you understand how money should be accounted in the business books.
Disclaimer The content of this article was written for informational purposes only. The author of this article is not a CPA or tax attorney. Every business is unique, tax laws, regulations, and state regulations are different.
