Obtaining a traditional business loan can be a difficult, lengthy, and intrusive process, especially if you’re a startup or looking to recapitalize your turnaround. That’s why many entrepreneurs choose to use personal funds in retirement accounts, savings, or equity in property. In this article, we’ll discuss the pros and cons of various ways of putting personal money into a business, and how to properly account for it.
If you have over $50K in your retirement account, you can use those funds to start, buy, or recapitalize a business without paying the usual taxes and penalties for early withdrawal. You can get started today with a rollover for business startups (ROBS) today by speaking with Guidant for a free consultation.
6 Ways to Invest Personal Money into a Business
Personal money is money that you have, receive, or borrow as an individual rather than under your business’s name. The best funding option using personal money will be heavily influenced by what resources you have, your family and network, and what your credit score is.
Making a quick list of your assets, liabilities, income, likely investors, and checking your current credit score will help you decide what funding options are most viable. Use our Assets and Liabilities Worksheet to properly inventory your assets, liabilities, and income and check your credit score for free here.
The table below shows a quick overview for each of the 6 best ways to fund a business with personal money.
Putting Personal Money into a Business: 6 Options at a Glance
|Rollover for Business Startups (ROBS)|
|What is it: A ROBS uses your retirement funds to fund your startup without paying taxes, early withdrawal fees, or taking on added debt.
Who it’s Right For: Individuals who have at least $50K in a qualifying retirement account and want to use those funds in their new business.
|What is it: Borrowing money, typically less than $50K, as an individual by using your personal credit profile and collateral.
Who it’s Right For: Those with a strong credit profile looking to get a loan for their new, or young, business that doesn’t qualify for financing yet.
|Consumer Credit Cards|
|What is it: Revolving credit lines for smaller amounts, typically less than $20K, borrowed as either an individual or a business.
Who it’s Right For: Credit cards are the most openly available financing to individuals and new businesses, and they can usually be used immediately after you’re approved.
|Home Equity Line of Credit (HELOC)|
|What is it: A revolving line of credit that is secured by your personal home, which works similarly to a credit card.
Who it’s Right For: Those who have more than 30% equity in their personal residence, and are willing to risk it for their business.
|Friends and Family Loans|
|What is it: Money borrowed from people you know at terms you come to an agreement on.
Who it’s Right For: Anyone who has access to money from people they know, or who are struggling to find funds in other places.
|What is it: Any cash you’ve accumulated that is liquid right now.
Who it’s Right For: Anyone who has a substantial amount of money in savings and either don’t have time to wait for financing or don't want to take on added debt payments.
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 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 loan, which means there is no big monthly payment that needs to be made immediately. It’s a good way to get funding into your business without burdening it with debt.
- It’s not a loan (no qualifying with credit scores and collateral)
- It’s not debt (no APRs, maturity dates, or big monthly payments).
- No penalties or taxes for early withdrawal
- Can pay yourself a salary
- If business succeeds, profits can grow in a tax advantaged retirement account
- Need to have $50K or more saved up in your retirement account
- You’re risking a portion of your retirement funds
- Must be full-time employee of company (no passive ownership)
- Could increase your chances of an audit from the IRS or Department of Labor (but a provider like Guidant will help you, if it happens).
Option 2. Using Personal Loans to Fund Your Business
Many traditional lenders will not give new businesses loans, at least not without a substantial amount of collateral. Because of this, many newer businesses tend to rely on personal loans instead. Personal loans can be obtained from your local bank or from an online lender such as Lending Club. They are a good choice when you’re 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 $40,000 from Lending Club)
Option 3. Using Consumer Credit Cards to Fund Your Business
Small 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.You can often borrow as either an individual or a business, but with a newer business you personally will likely have to guarantee the debt.
- Relatively inexpensive with rates ranging from 8-24%
- Since it’s a line of credit, you only pay interest on revolving balances
- Many cards let you earn rewards such as 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)
Our preferred small business credit card is Chase Ink Business Cash. The card offers up to 5% cash back and offers up to $300 bonus cash back if you spend $3K on the card in the first 3 months. Plus, there’s a 0% introductory APR for 12 months.
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
Quicken Loans can help you get a HELOC if you have a 620+ credit score, and at least 30% of equity in your home. They offer fixed rate loans with 8-30 year terms.
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)
- Speed in funding
- Inability to repay the loan could hurt relationships
- Unsolicited business advice from “investors”, even if you don’t give up equity
- Those with equity are legally entitled to some control over the business
Able Lending will handle the process of keeping track of funds and payments when you’re borrowing from someone you know. In fact, you may qualify for an Able Lending loan if you can find 10-20% of the loan from people you know. They offer rates as low as 8%, and 5 year terms. You can still decide what interest you pay to the people you know, for their portion of the loan, and Able Lending handles all of the administrative work. You pay them directly and they make sure each person you’re borrowing from gets paid when they should be.
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 financing 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
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
1. Consider the Risks of Using Personal Assets & 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 to get off the ground successfully, and for working capital going forward. 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.
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. You can visit Rocket Lawyer if you need help transitioning your business to an LLC.
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 other loans on your balance sheet. Additionally, if you loan your business money then you must charge it interest and pay personal taxes on the interest you earn.
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, the business won’t treat the investment as income. That is simply an owner investing in the company, and the taxes owed by the business won’t be changed by your investment.
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, for the business, that equity doesn’t have. Interest on a loan is considered a business expense, which reduces the business’s 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 the business’s 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 no tax 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.
4. Keep a Paper Trail, & 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, which we discuss below in more detail. 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’re 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. RocketLawyer can help with promissory notes, if you’re unfamiliar on how they should be drafted.
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.”
Proper Accounting When Putting Personal Money Into a Business
Every time money is put into your business checking account, your financial statements should change. You need to properly account for where the money is coming from, and what accounts it should go into. When you’re putting your own money into your business, you will want to make sure it is booked as equity, which gives you a claim to business assets. Here’s the five steps to properly account for personal money going into your own business:
1. Debit the Cash Account
The first step is making sure you create a journal entry that properly debits the amount of money you placed into your business checking account. This will show an increase in your asset account, and you can’t properly record the transaction anywhere else if your cash account isn’t showing the increase.
2. Credit the Capital Account
If you’re a sole proprietor, then take the same journal entry that you made as a debit, and make sure the same amount is credited in your capital account. If you’re a corporation, then the accounting for this step is a bit different. Instead, you should credit the common stock account by the amount you debited.
Your capital account or common stock account, depending on the type of business structure you have, is an equity account. Your equity account operates differently than an asset account for accounting purposes, because when you place a credit into the account the value actually increases.
3. Add the Amount of the Deposit to Your Cash Balance
Step three will likely be done for you if you have the right accounting software, but you should double check to make sure that it is done correctly. You need to add the amount of your deposit to the previous cash balance in your books. That new balance then becomes a new line item on your balance sheet, or the amount changes in your balance sheet. Your cash balance on the balance sheet falls under the “assets” section.
4. Add the Amount of the Deposit to Your Previous Account Balance
This step involves adding your deposited amount to your previous capital account balance or common stock balance. This is another step that should be done for you if you have a decent accounting software. Again, check to make sure it shows up on your balance sheet properly after you’ve made your initial journal entries.
5. Report New Capital Account Balance in the Owner’s Equity Section of Your Balance Sheet
This is the step you’re likely most interested in as the person putting the money into the business, if you’re also interested in taking it out at some point in the future. You need to either:
- Report the new capital account balance on your balance sheet under “owner’s equity”, or
- Report your new common stock account balance on your balance sheet under “stockholders’ equity”
There should be a total balance that shows up on the balance sheet, but there should also be a breakdown of equity by owner in your accounting software, or in the more detailed sections of your financial reporting.
A Final Word of Caution
Many small business owners operate freely without caring about how their personal funds and business funds are mixed together. This is especially common during startup mode. This is a very big risk that could hurt your business in the future, or could put your personal assets at an unintended risk.
“ Mixing business income and expenses with personal income and expenses can only lead to accounting confusion and mistakes, as well as create a lot of suspicion should your business be audited by the IRS or a state tax agency. Never pay personal expenses from the business account and always deposit business income in the business account, never in your personal account.
If you incur expenses personally that are business expenses, detail them and reimburse yourself from the business checking account. If your business is operated as a corporation or partnership, be sure that the company’s reimbursement policy that entitles you to reimbursement for these expenses is included in the corporation’s board meeting minutes or the partnership agreement.”
— Lee Reams, CEO at ClientWhys
These are great tips to live by if you’re looking to put money into your business, or if you’re looking to take it out for any reason at all, even a business purpose. 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. You want to always make sure your interests are protected, and that your money is properly accounted for as equity you’ve established in your business.
Bottom Line: Putting Personal Money Into a Business
At some point or another, most entrepreneurs rely on personal funds to finance their businesses. It’s important to weigh the risks of putting personal money into 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 for free about how you start or buy a business using your 401k or other retirement accounts.