Obtaining a traditional business loan can be a difficult, lengthy, and intrusive process. This is especially true for startups and businesses looking to recapitalize during a turnaround. That’s why many entrepreneurs choose to use personal money like funds in retirement accounts, savings, or equity in property.
In this article, we’ll discuss the pros and cons of various ways to invest personal funds into your business as well as way to minimizes tax and legal risks. For example, did you know that people with over $50K in their retirement account can use those funds to start, buy, or recapitalize a business without paying the usual taxes and penalties for early withdrawal? Click here to learn more about starting or buying a business using your retirement account with Guidant.
Disclaimer: While we aim to provide accurate content, Fit Small Business is not a law practice or legal professional. Click here to see our full disclaimer.
Six Ways to Invest Personal Money in a Business
Personal money is money that you have, receive, or borrow as an individual rather than under your business’s name. The top six ways to invest personal money into your business are:
- Retirement Accounts (ROBS – tax and penalty free rollovers)
- Personal Loans
- Consumer Credit Cards
- Home Equity Loans / Home Equity Lines of Credit
- Loans from Family and Friends
- Personal Cash Savings
Note: Your best funding option will be heavily influenced by what resources you and your family/network have and what your credit score is. Making a quick list of your assets, liabilities, and income, likely investors, and checking your current credit score will help you decide what funding options are most viable.
- Use our Free Assets and Liabilities Worksheet to inventory your assets, liabilities, and income.
Got your current credit score and breakdown of assets and liabilities? Great! Now let’s dig into the 6 ways to fund a business with personal funds.
Option 1. Using a Retirement Account to Fund Your Business (ROBS)
Some people invest funds from their 401(k), IRA, or other retirement account into their business. A Rollover for Business Startups (ROBS) allows you to do so without the penalties and taxes that accompany a simple early withdrawal. It’s a good way to start a new business, buy an existing business, or recapitalize a business.
One thing people love about using ROBS for new businesses is that you don’t start your business off in the hole. A ROBS is not a debt which means there no big monthly payment that needs to be made immediately.
Note: There are multiple tax and legal issues associated with a ROBS, so we encourage you to use a provider who will help you set up this type of financing.
- It’s not a loan (no qualifying with credit scores and collateral)
- It’s not a loan (no APRs, maturity dates, or big monthly payments).
- No penalties or taxes for early withdrawal
- If business succeeds, profits will grow in a tax advantaged retirement account
- Need to have $50K or more saved up in your retirement account
- Risking a portion of your retirement funds
- Could increase your chances of an audit from the IRS or Department of Labor (but a provider like Guidant will help you with that).
Option 2. Using Personal Loans to Fund Your Business
Personal loans can be used to fund a business. They can be obtained from your local bank or from an online lender such as Lending Club. They are a good choice when you are starting out in business and if you need a small loan quickly.
- Can be used to fund a startup or low-revenue business
- Faster and less paperwork than getting a business loan
- No collateral needed
- Competitive rates and terms
- Need good credit to qualify (check your credit score for free here)
- Loan amounts capped (up to $35,000 from Lending Club)
Option 3. Using Consumer Credit Cards to Fund Your Business
Credit cards can actually be relatively inexpensive, fast ways to get funding. As an added bonus, you may benefit from a promotional APR or from rewards programs.
- Relatively inexpensive with rates ranging from 8-24 %
- They’re lines of credit so you only pay interest on revolving balances
- Many cards let you earn rewards points or cashback on purchases
- Can help build your business and personal credit score
- Need good credit to qualify for a good card (check your credit score for free here)
- Some things can’t be paid for with a credit card, like payroll
Option 4. Using Equity in Your Property to Fund Your Business
Home equity loans (HEL) or home equity lines of credit (HELOC) are options that work well for those business owners who are short on cash but have lots of equity in their real estate. They can be an excellent way to channel personal funds into a business.
- Popular way to fund startups and existing businesses
- Very low interest rates (2.5-8 % APR on average)
- Rates could be adjustable and/or require refinancing quickly
- If you fall behind in payments, you could lose your home
Option 5. Using Loans from Family and Friends to Fund Your Business
Family and friends can be a great resource for small business owners trying to borrow money. They can invest in the business in exchange for an ownership share (equity), or they can loan money to the business. There are a number of places to get help drawing up the proper paperwork for these arrangements.
- No credit and collateral requirements
- Typically inexpensive (average APRs around 5-8 %, no closing costs or fees)
- Inability to repay the loan could hurt relationships
- Unsolicited business advice
- Those with equity are legally entitled to some control over the business
Option 6. Using Cash Savings to Fund Your Business
If you’ve set aside money in a savings account or investment portfolio you have the options of funding your business without any debt. You could also choose to loan the business money from yourself (for some, there can be tax benefits to such an arrangement).
- No creditors to repay and no interest owed
- Complete control over how you use the money and run the business
- Potential for liquidity issues
- Not leveraging your savings
If didn’t see the funding option you preferred, you can take the Fit Small Business fundability quiz at the bottom of this article to see your financing options.
Step-By-Step Guide to Putting Personal Money Into a Business
Once you’ve decided upon the best way to fund your business using personal money, you’ll want to consider four things:
- How much funding you’ll need vs. how much you’re willing to risk.
- What legal structure is best for your business
- How to treat your funding: equity or loan
- Maintaining a paper trail for all funds
If you’re planning to finance your business with personal money, read on for a 4-step guide on how to do so.
Step 1. Consider the Risks of Using Personal Assets and How Much You’ll Need
Howard Rosen, an experienced CPA and president of business consulting firm Conner Ash P.C., says the first thing he asks clients who are planning to fund their businesses with personal money is: Can you afford to lose it?
Although most people go into business thinking for certain that they will succeed, about half of new businesses fail in their first five years. Rosen cautions borrowers to be realistic about their chances for business success given the industry that they’re in and existing competition. If the business folds, the owner can lose their life savings, retirement funds, or other personal assets that they’ve put into the business.
Rosen also advises business owners to think carefully about how much money they will need for initial capital and working capital. Starting and running a business are often costlier than most entrepreneurs think. You want to ensure that you put enough money into your business but also hold onto enough personal assets for a rainy day.
If you have a day job or some other source of income independent from the business, that may allow you to put more personal money into the business because you have a regular inflow of cash.
Step 2. Carefully Choose Your Business’s Legal Structure
A business can be organized as a C or S corporation, LLC, partnership, or sole proprietorship. “The structure you choose will drive how you put personal money into your business,” says Rosen.
Most businesses start out as a sole proprietorship or partnership and later re-organize as an LLC or a corporation as they grow bigger. The advantage of LLCs and corporations is that they protect the business owner from personal liability for the debts and obligations of the business.
It’s more difficult to put personal money into a C or S corporation because of the formalities that need to be followed. For example, if you invest money into a corporation, you must issue shares and record the transaction in corporate ledgers. In addition, taking personal investments out of a C corporation is treated as a taxable dividend.
According to Rosen, personal money is a lot easier to move in and out of a sole proprietorship, LLC, or partnership. In particular, Rosen recommends LLCs as a structure to many small business owners because it offers almost as much legal protection as a corporation, but it’s a lot easier to transfer money in and out of an LLC.
Not sure whether to go with an LLC or another business structure? Check out our business structure guide.
Step 3. How to Fund The Business: Equity or Loan?
Personal money going into a business can be treated as equity (i.e. an investment) or as a loan that must be paid back by the business.
In general, if you are organized as an LLC, sole proprietorship, or partnership, it’s best to invest personal money and increase your equity in the business. Why? Because equity makes for a stronger balance sheet than a loan. Howard Rosen says banks and vendors prefer to work with businesses that have more equity than loans. Banks in particular want to make sure they get paid first in the event of a default, so they don’t like seeing a lot of other loans on your balance sheet.
Equity investments in a business are not taxable, says Micah Fraim, a Roanoke, Virginia-based CPA who offers tax, bookkeeping, and advisory services for small businesses. Taxable income arises only if there is revenue or sales of some kind. If you put your personal savings into your business, for example, that doesn’t count as income. That is simply an owner investing in the company. It’s not considered income, so it won’t be taxed.
If you put personal money into a corporation, you may want to consider treating it as a loan instead of as equity. If you invest money into a C corporation as equity, it’s impossible to get it back without taxation because taking the investment out of the corporation is treated as a taxable dividend. Even for an S corporation, money taken out in excess of what you put into the company is taxable.
This isn’t to say that you should never invest personal money in your corporation. Rosen advises clients to invest as much as needed for initial capitalization, but additional money put into the corporation for working capital or other needs should be treated as a loan so that it won’t be taxed.
Loans have a tax benefit that equity doesn’t have. Interest on a loan is considered a business expense, which reduces your taxable income. For instance, if you take a loan from a friend or a personal loan from a bank, you can deduct the interest on your tax return. However, if you loan money to your business from your own savings, the interest that’s deducted on your business return or Schedule C (for sole proprietors) must be reported as income on your personal tax return, so there’s ultimately no benefit.
If you get a loan from a family member or friend, even if they insist on giving you an interest-free loan, that’s typically not a good idea. Interest free loans may be deemed gifts by the IRS and subject to taxation.
Step 4. Keep a Paper Trail, and Separate Business Money from Personal Money
After you’ve decided whether to treat personal funds as equity or as a loan, the final step is to transfer the funds to your business checking account and to document the transfer in your business’ accounting records. If you later take funds out to give yourself a salary or for other personal uses, you should document that as well in your accounting records.
If you putting an equity investment in a corporation, ensure that you follow all corporate formalities in terms of issuing shares and recording the transaction in the corporate ledgers.
If you treat funds as a loan, you should document the loan in a promissory note. A promissory note is a legal document that authorizes the business to borrow from the individual. That individual can be you, a family member, a friend, etc. LegalZoom can help with promissory notes and much more.
Micah Fraim emphasized that it’s important for small business owners to have a clean paper trail (which often includes a promissory note). It is important for the paper trail to “make it very clear what the loan proceeds are being used for. If the paper trail is muddied, then in the event of an audit the IRS will be much more inclined to disallow the interest expense if the business use is unclear.”
Always maintain a separate checking account and separate books for business matters. Separating business from personal is especially important for LLCs and corporations. If you mix personal and business assets, a court could “pierce the veil,” meaning that it can hold you personally liable for the business’ debts and legal obligations. Rosen says even sole proprietors should have a separate business account and records so that they are not exposing personal assets to creditors in the event they can’t pay back a loan.
Fit Small Business Fundability Quiz
Considering financing for your small business? If you have 2 minutes to answer 10 simple questions, you can get a list of best-fit financing options for you and your small business.
At some point or another, most entrepreneurs rely on personal funds to finance their businesses. It’s important to weigh the risks of investing personal assets in a business and to have a plan B in case things don’t work out as planned. Putting personal money into a business isn’t complicated if you follow the four steps above, consulting a legal or tax professional as needed.
While normally you can’t touch retirement money without getting slammed by early withdrawal penalties and taxes, setting up a rollover for business startups (ROBS) avoids all of that. If you have more than $50k in a retirement account, speak to a ROBS professional at Guidant about how you start or buy a business using your retirement accounts.