Should I Loan Money or Invest in my Small Business?

We have been asked several times by business owners about their money contributed to the business.

As small business financial consultants, we have found the answer is different for every client.

There are several factors to consider when choosing one method over another.

See below for the comparison of what you can expect:

Pros and cons to loaning company money

• You will need to create a document defining loan parameters and payback terms, and you must execute according to that agreement.
• Loan terms, such as Interest, Amortization, Term, etc., must be at close to market rate. For tax purposes, a loan from you to your business 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 as income.
• One downside for a new company is, it will incur an interest payment (debt load) that will impact on some level the cash flow (depending upon the loan terms and size of the loan). This could prove to be difficult to service in the early stages of revenue growth.

Rules to follow when you loan company money

• The principal is not deductible to the business unless it uses the funds to purchase capital assets (which qualify for depreciation deductions.)
• One upside is the return of the principal on the loan is not taxable to you since the loan was after-tax money.

Related: 50 Best Tax Deductions to Write Off this Year

Pros and cons of classifying your investment as owner’s equity

• The company will appear healthier and have a higher valuation, as the loan (long-term liability) has been recorded as Owners Contribution (Equity)
• 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, good or bad to the business on this investment, except in their use of the funds to purchase depreciable assets (for which you will receive an appropriate write-off, typically over several years)
• Due to the healthier outlook, bank loans, Lines of Credit, attracting a partner or investor will all be much simpler and attainable

Rules to follow when investing in your company

• Valuation of the business will be higher, resulting in a higher resale price, higher share or percentage of ownership price for new partners/shareholders, and a higher limit when applying for bank loans or Lines of Credit.

As a St. Louis accounting firm, we love to help small businesses grow. If you have any questions about our services or you are interested in financial consulting for your small business, please contact us!