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Loans or Capital Injections

By Jason Watson ()
Posted May 5, 2019

The question comes up from time to time about how to fund the new venture. If you are the only owner, then any money going into the business should be deemed a capital injection and not a loan. For some reason small business owners want their business to owe them money; this typically does not make sense and also can set you up for problems down the road.

For example, you loan your business money and it goes bankrupt, your bad debt deduction might be limited as a short-term capital loss. According to IRS Publication 535, a business loan comprises of

  • Loans to clients, suppliers, distributors, and employees

  • Credit sales to customers, or

  • Business loan guarantees

As such the loan to your business might be deemed a non-business loan, and limited as a short-term capital loss.

Let’s not forget that you must impute interest expense to the business, and then subsequently pick up interest income on your tax return.

However, another situation might arise where you are partnering with someone else, and let’s assume you have all the money for startup funding. Recall the golden rule where the person with the gold makes the rules. As such, you might want to consider your funding as a loan to the business. This allows you to do two things; you can take money out of the business ahead of others as a loan payment (return of capital) and you can execute a personal guarantee from your other partner collateralizing the loan.

You can also convert your loan into additional equity. For example, you are a 50% owner and lend the business $100,000. Things are going great, however, the business does not have the cash to pay you back since all the cash is being re-invested back into the business. You might have a provision within the loan agreements that allows you to convert the debt into equity.

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