When starting a new business, there are few things more absolute than money. The popular saying ‘it takes money to make money’ personifies this concept. Unfortunately, good ideas alone do not get us to our goals. There are three ways to fund a new business, outside investment, business loans, or owner capital injection.
Outside investment is a loan from friends or family, venture capital, crowdfunding, or really any money from someone that is not a founding owner of the company.
A business loan is money borrowed from a bank or lending institution and includes interest and loan document charges. Usually, small business loans are expensive and require next to perfect credit. It is difficult for a new entrepreneur to secure funding if the business has not been operational for at least 2 years.
The third type of new business funding (and the most common) is owner’s capital injection. This includes money that the business owner takes from their own savings and pours into their new business venture. A business owner can categorize this personal money injection in two ways: by labeling it an owner loan, or an owner investment. Let’s break them both down.
An owner investment account falls under the equity section of the balance sheet. If you decide to pay yourself back for the injection you made then you may have to pay capital gains tax if the share price increases. And if you pay yourself additional money like bonus’, dividends, or draws you will be taxed. But there is no taxability to the business for this option.
An owner loan account falls under the liability section of the balance sheet. You pay yourself back the way you would pay any loan back as loan repayments against the liability. Keep in mind you have to perform this loan transaction as if you and the business have no prior relationship, this is called an arms-length transaction. You’ll have to draw up a contract in writing from you to the business with the expectations of repayment and if/how interest will be repaid. Without this document, in audit, the IRS could argue that the loan is invalid. And the benefit of a loan is that when the business pays you back there is no taxable event, meaning you nor the business have to pay any tax on this type of transaction.
Things To Remember
Some business owners get in the habit of spending their own money from their personal credit cards or checking accounts for business expenses. If you choose to do this, you will need to keep accurate receipts (I suggest scanning them into a business folder for record-keeping) and then reimburse yourself from the business account for money spent. Or you can transfer the money you intend on spending from your personal bank account to the business checking account. If you find yourself swiping your personal credit card a lot, I would suggest getting a DUNS number and applying for a business credit card. You will likely still have to guarantee the credit with your personal social security number, but this will help to build the business’s credit for future borrowing needs.
Additionally, it’s important to note that if the business fails and you have to file for bankruptcy, an owner loan means you are the creditor and could recover some funds on the loan. And the opposite is true for an owner investment. If the business files for bankruptcy, the investment is lost in the bankruptcy proceedings with no option for recovery.
The right option depends on the goals of the business owner, the performance of the business, and the amount injected into the business. If investment is $50,000 or more that is a large enough balance to constitute a loan agreement. However, if the owner is only investing $5,000 into the business, I would suggest keeping a simple investment account rather than a loan. Also, if the business is already doing ok and can afford loan repayments then the loan structure works perfectly. If not, you’ll want to go with an owner investment.