Everything you need to know about loaning your own business money
No matter how good your business idea, the likelihood is you won't be able to get it fully funded by investors. Thankfully, that doesn't have to mean that the dream is over. There are other options that allow you to put your own capital into the business.
However, when putting your own capital into the business you need to think about how you want to do it. You can either invest in your company or loan money to it. These two options are quite different and involve structuring your business in a different way.
Today, we are going to discuss if loaning money to your business is the right thing for you to do.
The difference between loaning to and investing in your business
If you are looking to put seed money into your own business then you have two options, loaning money to your business or investing in your business.
By investing in your business, you will be putting money into an owner's equity account or a shareholder's equity account (if more than one person is investing). If you want to withdraw your money at any point you will have to pay Capital Gains Tax on it.
If you take any other earnings from your business - like dividends or bonuses - you will also be taxed on these.
The major downside of investing, rather than loaning, is that if the business files for bankruptcy you will lose all of your investment with no way of getting it back.
However, investing gives you more flexibility over when you can remove your money from the business (as long as the said business is doing well).
If you are looking to loan money to your business then you will become the business' creditor. This is also known as Director's Loan. If you wish to loan money to your business then you will have to draw up a contract with your lawyers and accountants.
Any interest that you get paid from the loan will be taxed. However, the principal payments will not be taxed, as you will have already been taxed when you first earned the money.
If you want to loan your business money then you should invest in a good financial adviser and lawyer. You will want to make sure that this loan and your personal money are very separate from the business. This is in your best interest. Particularly if the business starts to have financial issues.
The more separate you can keep your accounts the easier your end of year tax forms will be.
Is it a good idea to loan money to your business?
There is a lot more legal red tape to deal with if you want to loan to your business. However, as a creditor, this is to protect your personal funds and is well worth the time you will need to spend on it.
If you want to loan money to your business you need to think about how the business will repay you. How often they will make these payments. How big these payments will be. What interest will you charge the business?
What you will do if the business can't make its next payment. What will you do if the business files for bankruptcy?
You will also need to think about whether you are going to secure the loan against anything physical. So, for example, you have the right to take stock or equipment as payment if they cannot pay their loan.
Before making any of these decisions you should talk to a financial adviser. They will be able to help you decide if loaning your business money is the best option for you. For some businesses, it works very well, while for others it can cause a lot of problems and complications.
The real benefit of choosing a loan over investment is that your money will be more secure. You can have foreclosure and legal imperatives written into your contracts. Meaning that if the business is struggling, paying you back will still have to be a priority for it.
If you do choose to loan your business money then you will have to be very careful when setting up the loan. We will cover what you need to do in more detail later, but it is important that there is a clear paper trail and you are keeping the IRS (Internal Revenue Service) in the loop.
If you are audited, then you will need to have as much documentation on hand as possible. Your accountants will be able to talk you through all of this.
How do I loan money to my business?
If you want to loan your own business then you will need to be very clear about separating your personal and business accounts.
You will want to begin this process by having your financial adviser and attorney draw up a loan agreement. This arrangement will detail:
- How much you are loaning the business
- How long you will be loaning the money for
- What the interest rates on your loan will be
- How often you will be repaid
- How much each payment will consist of
- Any consequences there will be if the payments are missed or the loan is not repaid
You may also wish to put a limit on what your loan can be used for within the company. You could have it specified that the loan is exclusively used to pay wages or any other purpose you desire. Although this final option is not necessary.
For tax purposes, this loan will have to qualify as an arm's length transaction.
This means that neither party has a fiduciary duty to the other that would create inequality and that both parties have to have equal bargaining rights during the loan negotiations. This type of transaction also has specific rules about the relationship between the two parties.
They are as follows; both parties must be independent (this is to prevent funneling personal funds through business i.e money laundering), and they do not have a close relationship (i.e you cannot make this loan to a family member or spouse).
Without a contract that has a clear legal president, it is possible for the IRS to reject this loan and investigate it. Possibly for tax fraud. Therefore you want to take your time when drawing up the loan and make it as clear as possible that both parties are distinct and aware of their obligations.
Are there any tax implications of loaning money to my business?
Lending your business money will affect your personal finances and tax reports. You need to be aware of this before you make a loan and prepare for it.
After a messy case in 2008, the Tax Court set out guidelines for the process of correctly loaning your business money. While these laws exist to protect businesses from loan sharks, they are also designed to protect people making genuine loans to their own companies.
The court stated that a loan will not be approved unless the following things are done:
- Written paperwork detailing the relationship between the creditor and the business
- A detailed description of the loan and what form it will take
- The repayment plan and expectations - including the terms and conditions of the loan
- A clear plan of what will happen if the payments are missed or bankruptcy is filed for
As a creditor, you have to be aware of the difference between making a loan and an investment - and what that means for your money.
There will be a limit on how quickly you can get your money back, as depicted in the loan agreement. When you invest you can withdraw your money whenever you want, this is not the case with loans.
However, with loans you will not have to pay tax on the principal repayments only on the interest. When you invest, any more you withdraw from your company will be taxed - most likely it will be Capital Gains Tax.
You should only loan money that you can afford to go without for a few years, as you will not be able to pull this money back out of the company without creating legal issues.
That being said, if you have the means to do this, then this can be a great way to put seed money into your business.