Every 12 seconds, a home-based business starts, and currently there are 38 million home-based businesses in the US.
One of the most important pieces of any new business is working capital or money to get the company started. Loaning money to your own company may sound like it is the easiest method, but it has legal and tax implications.
You could also choose to invest the money in your company. This is an important decision you need to make early in the business forming process.
Read on to learn more about the difference between loaning and investing in your new adventure.
How to Finance Your Start-Up or Home-Based Business
There are three main ways to loan money to your company: You can have the company take out a loan, loan your own money to your company, or invest your own money in your company.
Each method has its own tax and legal implications. Regardless of the type of your business, home-based, start-up, or newly growing, moneybanker.es has financial resources for business people to start and grow a business.
Borrowing Money to Start Your Own Company
If you choose to borrow money to start your own company, you can seek out friends and family or apply for a commercial loan through your bank or the Small Business Administration.
All of these avenues have risks and benefits. You should consider them all, as well as what happens in the worst-case scenario, that the company fails.
Borrowing from Friends or Family
It goes without saying that borrowing from friends and family can be risky to your relationship. Think about the implications of this risk before you jump in.
If you do choose to borrow money, make sure you have a legal document drawn up that outlines payments, interest, the term of the loan, and what happens if the loan is not repaid.
The latter may not be a thought in the beginning, but some small businesses fail. Approximately 30% of new businesses fail in year 1, 50% by year 5, and 66% by year 10.
When you write up a loan between family members, the goal is to create an arm’s length transaction. In essence, this means you are following the same rules as any other business and you are preventing a conflict of interest.
For example, you cannot list a debt against the company if the money is given to you with no expectation of receiving anything in return. Also, if a bank would require collateral to secure your loan, then you should consider providing the same assurance to a family member or friend.
If the company fails, and you file bankruptcy, creditors are paid before investors. However, you have no ability to control if your family or friends receive all, some, or none of their original loan back.
Borrowing from a Bank
Banks and the Small Business Administration loan money to new companies every day.
The process to obtain a loan often requires collateral such as a house or car. Bankers will expect a business plan that includes a marketing plan and financial projections. They will also look at your personal credit score.
This may be the cleanest way to fund your startup, as it has the most limited number of personal, tax, and legal risks.
Loaning Money to Your Own Company
When you loan money to your company, you are creating debt for the company. You are also becoming the lender. The idea is that the company will then have to repay your the money, principal plus interest, on a monthly basis.
In order to ensure that you are not violating tax law, this loan has to be at arm’s length as well. Even though you are loaning to yourself, you need to write terms that any other lender would expect and then follow them.
In this case, as well as when family members are loaning money, the best course of action is to have a third party draw up the paperwork.
Keep in mind, if the company fails, creditors will be paid out of the remaining funds or assets before the investors. You cannot ensure that you will be paid before your other creditors.
Interest paid on debt by the company is an expense, which benefits the company at tax time by lowering the amount of taxes paid.
The interest you receive is considered income and may affect your tax status, causing you to pay more in personal taxes.
Investing Money in Your Own Company
In this instance, you are treating your business as an investment. You are not expecting regular loan payments, but are banking on its success, in the long run, to ream you a financial reward.
When you withdraw your contribution or investment, you may have to pay individual capital gains tax.
Any other monies you withdraw from the company, such as bonuses, dividends, or draws, will affect your personal taxes.
The business in this instance will have no tax consequence.
In the situation of bankruptcy, you should expect no return on your investment. The only benefit to your personal taxes is that you can take that investment as a loss.
More Resources for the Small Business Owner
As a small business owner, you are responsible for everything having to do with your business. This includes the sides of the business that may not be in your expertise, determining if you should be loaning money to your own company.
Take advantage of the resources for starting a small business that exist to ensure yours is successful.
