Lending to Your Business? Do it Right

Where does your business go when it needs a loan? For many small businesses, the answer is…right back to the owner.

If you have to lend money to your business, do it the right way. There are potential tax benefits for loans to your own business. There also are financial potholes that you could hit if you don’t do things properly.

Here are five things to consider.

1. Making and guaranteeing loans are different. Guaranteeing a loan the company takes is not the same as making a loan to the company yourself. If the company takes out a loan, that does not increase your basis. For owners of S corporations, that means you cannot take into consideration the loan when calculating any pass-through of losses from the business to your personal return.For example, if you own a company in which you have $5,000 in equity and for which you have guaranteed a $10,000 loan, only $5,000 of company losses could be passed through to your current personal tax return. If you had made the loan directly to the company, your basis would have increased to $15,000, and any losses up to that amount could pass through to your personal return.”It goes back to the concept for S corporations that losses cannot exceed the sum of the shareholder’s basis in the stock and any direct debt the shareholder has in the corporation,” says Los Angeles tax attorney Thomas Henning, a partner in the firm of Allen Matkins Leck Gamble & Mallory LLP.

2. Initial investments usually aren’t loans. If you’re just in the process of starting a business, don’t try to say that the money you’ve initially put into your corporation is a loan rather than a purchase of stock. That’s a no-no. You have to actually put money into a company for the stock purchase involved in a startup, and that money cannot be repaid to you as if it had been borrowed. You can lend money to the corporation once it is established.

3. Document all your loans. This may sound obvious, but you don’t want to make a loan just by writing a check to the company. You have to document what you’re doing properly as being a loan from you to the corporation. You’ll need to draw up a promissory note and specify a rate of interest on the loan and terms of repayment. You should also keep proper track of repayments of loan principal and interest. Failing to charge interest on the loan can result in a terrible double-whammy. One, you could have interest “imputed” to you — that is, the IRS could say you have to pay tax on money you should have received. Two, if your business is a C corporation that is losing money, the additional interest deductions simply will be added to the corporation’s retained losses. In short, no current tax benefit for the payments made.

4. Watch your ratios. Proper documentation may also help you avoid having the loan re-characterized by the government as something else, such as an additional equity contribution. While from a tax standpoint it can make more sense to loan money to your business than to invest additional funds, there may be limits on how much you can actually lend. Some business advisors suggest not having a debt-to-equity ratio of more than, say, 3-to-1.”The problem is that if the IRS feels your debt-to-equity ratio is excessive, they may say that the debt is really disguised equity,” Henning says. “If that’s the case, then those payments the company is making that you think are loan repayments could wind up being characterized as you giving yourself a dividend.”That can make a huge difference in your taxes. Only the interest on loan repayments is taxable, but all of a dividend would be subject to tax. Additionally, a corporation could deduct as a business expense the interest charged on a loan. But if the money being paid out is a dividend instead, none of it would be deductible by the corporation.

5. There’s no such thing as a simple loan. You also may have to deal with passive-loss rules and other issues when you lend money to your business. As with any complicated financial or business dealings, it makes sense to consult with your tax pro or attorney and other professional advisers before moving forward.

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