An initial boost of cash to keep operations afloat until the company can support itself may be obtained through outside funding. However, if an owner has cash available, then follow our guide on how to loan your business money. The process begins with creating a formal agreement. Next, you’ll transfer funds from your personal bank account to your business one. Finally, you’ll separate business documentation from personal records.
Key Takeaways
- When loaning money to your business, document loan details the same way you would in a loan agreement to an outside party.
- Market rate interest should be charged on loans made to your business.
- For C corporation (C-corp) shareholders, interest income from a loan to the business is an additional option to withdraw money without wage (subject to Social Security and Medicare taxes) or dividend classification.
Step 1: Create a Formal Agreement
Without a contract, the IRS could determine that the loan is invalid and reclassify the loan as a contribution. This reclassification could have a further downstream impact, including the disallowance of the interest expense deduction taken by the business.
The formal agreement should do the following:
- be structured like a legitimate loan that would be made between two independent parties
- include a detailed repayment schedule
- address what constitutes a loan default and default ramifications
- set a reasonable interest rate; the IRS sets applicable federal rates (AFRs), which can be used as a guide for current market rates
In place of a single loan, you could also extend a line of credit to your business, which can be drawn on as needed and repaid monthly with interest. As with a typical installment loan, the terms of the line of credit should be carefully documented to solidify its business purpose and support the legitimacy of the loan with the IRS.
Step 2: Transfer Funds
Once the two independent parties have agreed upon the payment schedule, default ramifications, and other relevant factors, write a check from your personal bank account to your business bank account. You can also transfer funds electronically.
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Step 3: Separate Business Documentation From Personal Records
Maintaining separate personal and business books and records is vital to supporting your loan position. The business records should show the receipt of the loan as a note payable. As payments are made, a reduction of the note payable and a deduction for interest expense should be recorded. As the lender, you should personally track interest income from the loan and report it on your personal tax return.
Expert Tips on Loaning Money to Your Business
1. Decide When a Capital Contribution Is Preferable to a Loan
In general, an investment in the company might be preferable to a loan if you are planning to solicit investors and want to minimize the obligations shown on the company’s balance sheet. This is one of the main benefits of contributing capital to your business as opposed to issuing a loan. A future investor or lender may be more comfortable doing business with a company that has fewer outstanding obligations and a larger financial commitment from the founder.
2. Consider Shareholder Investment for Your S- or C-corp
If an individual shareholder’s investment in the corporation would qualify for small business corporate stock (Section 1244) treatment, a contribution to the corporation may be preferable to a loan. Section 1244 treatment means that if the corporate stock is sold for a loss, the loss would be treated as ordinary.
An ordinary loss can generally reduce tax on the portion of the taxpayer’s income subject to higher rates. So, without Section 1244 treatment, a loss on disposition would primarily offset the portion of the taxpayer’s capital gains subject to lower rates.
There are additional criteria that the corporation, stock, and stockholders must adhere to to be eligible for this benefit. However, if all parties meet the eligibility requirements, then an investment might be preferable to a loan.
3. Be Mindful of the Tax Impact of Bad Debt Expense
If the legitimacy of the loan can be supported, then you can deduct the bad debt expense. However, the tax impact of the deduction depends on whether the debt is a business or nonbusiness bad debt.
- Business bad debts can be fully deductible even when the debt becomes partially worthless.
- Nonbusiness bad debts offset capital gains, which are usually taxed at a lower rate than the rest of your income. Once any capital gains you have are absorbed, you get an additional $3,000 deduction on your current year’s tax return, and any leftover losses from the bad debt would have to be carried forward to future years. Nonbusiness bad debts can be taken as losses in the year the full debt becomes worthless.
4. Keep the IRS from Reclassifying Your Loan as a Distribution or Dividend
If a loan to a business is not properly documented, the IRS could reclassify the loan repayment as a distribution or a taxable dividend. Distributions may also be taxable if the taxpayer does not have enough basis to take the distribution. In general, basis represents the taxpayer’s investment in the business.
To determine if the loan being made is legitimate, multiple factors need to be considered.
- If the amount, repayment terms, and interest assessed make sense
- If recordkeeping is adequate
- If there is a limit in any agreements to the amount of loans issued to the corporation
- If the repayment requirement is evident in the loan agreement
- If the interest was paid or accrued
- If the corporation provided the owner with any collateral
- If a maturity date was established in the loan agreement
- If any attempts were made to repay the loan
- If the transaction was treated the way a loan would be conducted between two external parties
Advantages & Disadvantages of Loaning Money to Your Business
| Advantages | Disadvantages |
|---|---|
| It doesn’t require external credit checks. | If the business defaults on the loan, you may suffer financial hardship along with the business. |
| It has no processing fees. | If you borrowed to make the loan (e.g., using a home equity loan), a default leaves you with additional outside debt. |
| It’s a quick process—you just need to make the transfer. | Cash lent to the business is now tied up and can’t be used for other investments. |
| You control the loan terms and can make them borrower-friendly but still arm’s length. | |
| In the event of default, you’ll have equal standing with other creditors. | |
| For C-corps, interest income can move to the lender-shareholder without being a taxable dividend or compensation subject to Social Security and Medicare taxes. | |
General Tax Considerations
Loaning money to your business comes with tax considerations.
Overall Business Impact
- The interest expense incurred by the company is a fully deductible expense for entities with gross receipts averaging $30 million or less during the three previous years starting in 2024 (indexed annually for inflation).
- Loan repayments of principal are not deductible to the company.
Owner or Lender Impact
- The interest income received by the owner is taxable on the owner’s personal income tax return.
- The principal of the loan issued is not deductible, nor is the repayment of the principal taxable.
Special Notes for Member Loans to LLCs Taxed as Partnerships
- Capital contributions by a member increase that member’s capital account in the LLC.
- Loans from a member to the LLC don’t affect their capital account, but they do provide a basis for the LLC to deduct LLC losses.
- The member issuing the loan records interest income according to their own accounting method.
- The business paying the interest expense records those payments according to their own accounting method, even if it is different from that of the lending member.
- Administration of multiple loans that occur during a year can be simplified by setting up a master loan agreement between the LLC and the member. The master loan agreement would be similar to a line of credit. This umbrella agreement could help consolidate recordkeeping.
- If the IRS deems that the loan is invalid, the transfer from the owner to the LLC is considered contributed capital. Interest income is then treated as a guaranteed payment.
Frequently Asked Questions (FAQs)
To put personal money in your LLC, transfer funds from your personal bank account to your business bank account. This can be done by check or electronic transfer. Unless carefully documented as a loan, the amount transferred will be considered an owner’s investment.
Businesses borrow money by applying to external lenders or by taking loans from owners. For guidance, see our article on how to get a small business loan.
Yes. However, there may be additional tax and legal considerations if your LLC has other members.
Issuing a loan to your business is not a tax write-off for you or the business. You’ll need to record interest income, and the business can deduct interest expense in full as long as it does not have more than $30 million in gross receipts in 2024 for the three previous years.
Bottom Line
Now that you’ve learned how to loan your business money, you know that it can be an excellent plan if your business needs quick funding and friendly loan terms. To hold up under IRS scrutiny, the loan agreement should be constructed in the same manner that it would be if made with an outside party.
