With the pandemic waning, the time for government assistance programs ending, and the economy growing, your business may need money now. Additional financing may be useful to expand your activities, hire additional employees and increase compensation and employee benefits, or just to pay for the rising price of inventory or other items you need.
Instead of looking for outside capital, you may have the financial ability to help your business by lending it money. Things can get complicated, so be sure you understand what you’re getting into.
Formalities of lending money to your business
When you loan your business money, be sure to formalize the agreement. Terms should include: interest (discussed in detail later), a repayment schedule, and what happens upon default. It’s helpful but not required that you have the agreement notarized; just another formality to show the loan is bona fide.
The business needs to treat the money it received as a loan. It should be carried on the balance sheet as such and repayment should be factored into the business’ budget.
Interest. Generally, you should charge a reasonable rate of interest. As the lender, you report this as interest income. The business deducts the interest payment, subject to the limit on business interest expense.
If the loan has an interest rate below the IRS-set applicable federal rate (AFR) for the term of the loan, you are treated as having made a below market loan. You have phantom interest income for the amount you didn’t receive but should have charged (the amount below the AFR). As a practical matter, with interest rates low, the AFRs are very modest (e.g., 2.08% on a long-term loan made in June 2021, with annual compounding).
The advantages of self-financing
Using your own funds is the simplest way for your business to borrow money. No application form, credit check, or any other hassle. Be sure to carefully document the loan and treat it as such (i.e., carry it as a debt on the business balance sheet, make required repayments).
If your home has appreciated in value, you may be able to borrow money by tapping into your home equity. Generally, the interest rates are modest and you can then lend the money to your business. While the interest on a home equity debt used for personal purposes (e.g., vacation, education) is not currently deductible, the interest becomes deductible where the proceeds are used for business purposes.
If you are an S corporation and lend money to it, you can increase your tax basis. This may enable you to take a biggest tax loss if the business isn’t profitable.
The disadvantages of self-financing
Obviously, if your business can’t repay the loan, you not only lose out businesswise but have also depleted your personal resources. If you obtained the funds for the loan via a home equity loan, you risk losing your home unless you continue to serve the debt.
Writing off the loan. If the loan is not repaid and you can prove it was a bona fide loan (and not a contribution to capital), you may be able to claim a bad debt deduction. But it’s complicated.
If you lent money to your incorporated business, the loan is a business bad debt if made to protect your compensation but a nonbusiness bad debt if made to protect your investment.
Why does this matter? Business bad debts are deductible as ordinary income, while nonbusiness bad debts that become are wholly worthless (i.e., no possibility of recovery) are treated as short-term capital losses. They can only offset capital gains and then up to $3,000 of ordinary income. Because no itemized deduction for the ordinary loss is permissible through 2025, only loans having a dominant motive of protecting investment are currently deductible.
If you give your personal guarantee for the business to obtain a loan, you don’t get any tax breaks even though you potentially are on a financial hook. If you’re called upon to pay the loan because the business can’t, then you may be able to deduct the interest on the loan.
There’s wisdom in using OPM (other people’s money); you preserve your personal wealth. But it may just be easier and more practical for you to loan money to your business.
As Tyler Perry, actor, director, producer (and highest paid person in entertainment in 2011 and has a personal net worth over $1 billion), said: “The thing about using other people’s money is they’re going to set the rules.”
Use your own and stay in control, but be sure you understand the risk, the tax ramifications, and the financial implications.