Lending money to your own business

When an owner moves $50,000 from a personal account into the business account, the transfer itself says nothing about what it is. It could be a capital contribution, which increases the owner’s stake and is repaid only when the company distributes profits or is sold. Or it could be a loan, which the company owes back on fixed terms with interest, ahead of any return to owners.

The two are treated very differently, and the difference is decided by evidence. If the IRS, a bank, or a buyer looks at the books and sees a transfer with no note, no rate, no schedule, and no payments, they will tend to treat it as equity, whatever the owner intended. The consequences follow from that.

• Repayment. Money the company pays back on a documented loan is repayment of principal, not income to the owner. Money paid out against an undocumented advance may be treated as a distribution or, in some cases, as wages, with the tax that goes with that.
• Interest. Interest on a genuine loan is generally deductible by the company and taxable to the owner. On an advance recharacterized as equity, there is no interest to deduct.
• Basis and losses. How an owner’s advance is characterized can affect their basis in the company and their ability to use its losses. The rules differ by entity type.
• Priority. If the company fails, a documented creditor stands ahead of owners. An undocumented advance is usually treated as the owner’s money at risk.

An accountant preparing the return, a bank underwriting a line of credit, and a buyer doing due diligence will each ask the same question: show me the note. Having it is the whole point.

The company is the borrower and the owner is the lender. The promissory note is signed by an officer of the company, which may be the same person wearing a different hat. That is normal, and it is exactly why the document needs to be complete: it has to stand on its own, without anyone’s memory to support it.

• The legal name of the company as borrower and the owner as lender.
• The principal amount and the date it is advanced.
• A fixed annual interest rate.
• The term and the repayment schedule: amortizing monthly payments, interest-only with principal at maturity, or a single payment.
• The maturity date.
• Whether the loan is secured, and if so by what. Many owner loans are unsecured.
• What happens on default, including the owner’s right to demand payment.
• Whether the company may repay early without penalty.

A loan that is meant to be repaid “when the business can afford it” should still have a maturity date. Open-ended terms are one of the signs that an advance is really equity. See what a promissory note is for each clause in detail.

A rate of zero is another sign that the advance is not really a loan, and for a corporation it brings in the below-market loan rules of section 7872, which apply to loans between a corporation and a shareholder as well as to gift loans between individuals. The practical floor is the applicable federal rate for the month the loan is made and the band that matches its term.

A rate at or somewhat above the AFR is defensible. A rate far above what the company could get from a bank invites the opposite question, of whether the interest is really a disguised distribution. Somewhere between the AFR and a commercial rate for a business of similar size is the usual answer. On $50,000 at 8% over five years, the company pays about $1,014 a month and about $10,800 in total interest; the loan calculator shows other combinations.

Interest actually paid is income to the owner and must be reported. The company issues the appropriate information return where one is required.

A loan from an owner is a transaction between the company and an insider, and it should be approved in the way the company’s governing documents require. For a corporation that is usually a board resolution. For an LLC it is a consent of the members or managers, as the operating agreement provides. Where there are other owners, their consent protects everyone, including the lender, from a later claim that the loan was improper.

Then record it in three places.

1. The minute book, with the resolution and a copy of the signed note.
2. The general ledger, as a loan payable to the owner, not as capital.
3. The loan’s own ledger, which tracks interest accrued and each payment.

If the company has, or expects to have, a bank loan, check the loan agreement before signing. Many bank facilities restrict the company from taking on other debt, or require that owner loans be subordinated to the bank.

The evidence that a loan is a loan is built month by month. Each payment from the company to the owner should be made on schedule, recorded against the note, and split between interest and principal in the way the amortization schedule sets out. The company’s books show a reduction in the loan payable; the owner’s records show interest income.

Skipped payments that are never caught up, or payments that vary with the company’s cash position rather than the schedule, are what an auditor will point to in arguing that the arrangement was equity all along. If the company genuinely cannot pay, amend the note in writing and have both sides sign the amendment, so the record shows a loan being managed rather than ignored.

A loan kept in NoteHouse gives the owner and the company the same ledger, with the schedule, each payment, and the running balance in one place that an accountant can be given access to at year end.

Businesses fail, and owner loans are often the last to be repaid. What happens then depends on how the loan was documented and on the entity type, and this is where the owner should sit down with their accountant rather than rely on general rules.

Broadly, there are three outcomes.

• The loan is written off. A loan that was genuinely made in the course of the owner’s business may be a business bad debt; one that was not may be treated as a nonbusiness bad debt, deductible only as a short-term capital loss when it becomes wholly worthless. The distinction turns on facts, and the signed note and payment history are the first facts examined.
• The loan is converted to equity. The owner forgives the debt in exchange for a larger stake, or simply contributes it to capital. This should be documented with the same care as the original loan.
• The loan is forgiven. Forgiving a debt owed by one’s own company can have tax consequences for the company, which may have income from the cancellation, and for the owner’s basis.

None of these is simple, and the right one depends on the company’s structure and the owner’s other circumstances. The documentation described in this guide does not decide the outcome, but without it the options narrow quickly.