Using personal money in your business can address funding needs but can also create unnecessary risk and potential tax consequences if not done correctly. Here are the four steps to follow when using personal funds in your business:
1. Establish a Business Checking Account
One of the most important things a small business owner should do is separate business and personal monies. A business checking account provides a level of protection for your personal assets. Additionally, establishing a legal entity for your business provides additional protection. We will discuss this in more detail later in the article.
If you don’t have a business checking account, Novo is one option to consider. A fully online bank, it offers free automated clearing house (ACH) transfers, the ability to generate and mail checks on your behalf, and no-cost incoming wire transfers. Its application process is quick as well.
2. Determine the Source of Personal Funds
There are several ways you can use personal money to fund your business. Each of these paths has varying levels of complexity and potential risk, as you are utilizing your personal assets.
Six ways you can use personal funds to invest in your business include:
- Rollover for business startups (ROBS): ROBS are designed for individuals willing to use over $50,000 of retirement savings to fund their business.
- Credit cards: These provide up to $20,000 in accessible credit with rates generally between 11% and 30%.
- Home equity loans: Individuals who have at least 20% of their home’s value in available equity can utilize this to fund their business.
- Personal loans: Entrepreneurs with strong personal credit can take out personal loans to fund their business, if necessary.
- Friends and family loans: These are ideal for those friends and family who have the money and are willing to help support your business idea.
- Cash savings: This refers to money that’s “liquid” and can be accessed easily.
When deciding on the best funding option, it helps to make a list of your assets, liabilities, income, likely investors, and your current credit score. You can use our Assets and Liabilities Worksheet to assist. Once you complete the list, evaluate it to determine which option is best for putting personal money into your business.
A ROBS allows you to fund your business through your retirement savings without the penalties and taxes that accompany an early withdrawal. It’s a good way for you to use your own money to either start, buy, or recapitalize a business. A ROBS isn’t a loan, which means you don’t need to make a monthly payment.
You typically need at least $50,000 saved up in a qualified retirement account to make a ROBS worthwhile, and you should remember that your retirement funds are at risk. Prior to setting up a ROBS, you should be aware of all the tax and legal implications involved. An experienced ROBS provider, such as Guidant, can offer expert advice to help you make an informed decision.
Using credit cards can be a relatively fast and inexpensive way to get funding. As it may be hard for a startup to get a business credit card initially, you can use a personal credit card for business. Make sure that you don’t mix personal expenses with business expenses on any credit card that you utilize.
Credit cards have relatively low interest rates, allow you to build credit, and offer promotional or rewards programs to qualified borrowers. We recommend checking out our articles on small business credit cards to help you find the best one for your business.
Home Equity Loans
Home equity loans and lines of credit are options that work well for business owners who are short on cash but have significant equity in their personal real estate. Both typically offer some of the lowest interest rates of any financing option, with funding often available within a few weeks.
Using the equity in your home can be risky as your house is put up as collateral for the loan. If your business doesn’t succeed, you still need to make payments on borrowed funds.
Most traditional lenders won’t give loans to new businesses, which leads many business owners to rely on personal loans instead. Funds can be accessed relatively quickly, and no collateral is required for an unsecured personal loan. Business owners with good credit should qualify. However, loan limits tend to be small.
Loans From Family and Friends
Your friends and family may sometimes be willing to lend you money. They can also invest in your business in exchange for an ownership share. While borrowing from friends and family may be a tempting option, it’s important to consider the implications this can have on your personal relationships, especially if the business fails.
Loans from family and friends should include an agreement with terms and conditions established on repayment of monies borrowed.
If you have money set aside in a savings account or investment portfolio, you can finance your business without any debt. This can be done either as your personal loan to the business or, preferably, an equity contribution.
While using personal cash is a low-risk way to fund your business, make sure you maintain enough personal savings to cover any unexpected personal expenses that may arise.
3. Transfer Personal Funds Into Your Business
Once you put your personal money into your business, you can classify it as either equity or a loan. Most business owners list this transaction as equity, meaning the funds are a contribution and that the business doesn’t owe you repayment. This transaction means that you are making an investment in the future success of the business in return for an increased equity stake.
How you record the transaction determines the accounting process and how you receive money back from the business later. Make sure you keep fully documented proper records of this transaction so that your balance sheet and taxes are accurate.
4. Record the Transaction Properly in Your Accounting Software
We highly recommend that you have accounting software that tracks your business expenses and that you take steps to ensure all expenses and revenue are updated on a consistent basis. These bookkeeping tips are helpful for ensuring that your business finances are managed and tracked properly.
What to Consider When Putting Personal Money Into Your Business
While the process of putting personal money into your business isn’t difficult, costly mistakes can be made that could hurt your personal finances in the long run. It’s a good idea to trust expert advice before using personal money so that you don’t hurt your finances or increase your taxes later.
Evaluate the Risk of Using Personal Assets
While most entrepreneurs believe their business concept will succeed with certainty, nearly half of all new businesses cease to exist within five years. If the business fails, the owner could lose any savings, retirement funds, or other personal assets that they have put into the business.
If you haven’t done so already, we recommend developing a robust business plan that includes details on how much money you need to fund your business and the sources of those funds. If you have sufficient personal assets to fund your business and also have a reserve for emergency expenses that may arise, using personal assets makes sense.
Which Legal Business Structure Is Right
A business can be organized as one of multiple business structures such as a corporation, limited liability company (LLC), partnership, or as a sole proprietorship. The advantage of LLCs and corporations is that they protect the business owner from personal liability for the obligations of the business. Note that it is more difficult to move personal money into a corporation due to the formalities that need to be followed, such as issuing shares of stock, so an LLC may be a better entity.
Talking to an accountant or attorney about the best option for your business’s legal structure is a good idea. Both offer you advice on the potential implications of changing the business structure.
There are additional things to keep in mind with using personal money in your business. Neither recording the transaction as equity nor as a personal loan to the business allows you to take your investment as a deduction on your personal taxes. However, there are tax advantages that the business may receive when the business pays you interest on the loan or you sell your ownership interest in the business.
Structuring Your Investment as a Loan
If you’re lending your business the money, you’ll need to make sure you have the proper paperwork drafted to acknowledge what the business owes you and how the business repays the loan. The business needs to make regular payments, and you’ll have to charge at least a nominal amount of interest to make the transaction legal and to fill out your personal taxes correctly. Any interest payments show up on your personal taxes as income.
Loans have a tax benefit for the business that a contribution doesn’t provide. Interest on a loan is considered a business expense, which reduces the business’s taxable income. However, if you lend money to your business from your own savings, the interest that’s deducted on your business return or Schedule C, if you are a sole proprietor, must be reported as income on your personal tax return, so there’s no personal tax benefit.
Making an Equity Contribution
If you make a contribution to your business as an investment, then you just need to make sure the business properly accounts for your money in this way. This is to ensure you are properly compensated if the business is sold, you cash out your ownership, or the business pays dividends to its owners. Any money you receive due to your ownership will be reported on your personal tax return as income.
Many entrepreneurs rely on personal funds to finance their businesses as they start up, but when doing so, it’s important to weigh the risks. It’s equally important to follow accounting best practices. Learning how to invest in a business isn’t complicated, but you need to do it correctly, so consulting a legal or tax professional as needed is a good idea.