Loans or Capital Injections

By Jason Watson, CPA
Posted Saturday, August 3, 2024

We broached this from an investor perspective earlier and is largely repetitive. This tiny section expands on the notion of your cash going into the entity, and how that might be problematic.

The question comes up from time to time about how to fund the new venture. If you are the only owner, then any money going into the business, real estate investment or rental property entity should be deemed a capital injection and not a loan. For some reason small business owners and real estate investors want their entity to owe them money; this typically does not make sense and can set you up for problems down the road.

For example, if you lend your entity money and it goes bankrupt, your bad debt deduction might be limited as a short-term capital loss. According to IRS Publication 535 Business Expenses, a business loan is comprised of-

• Loans to clients, suppliers, distributors, and employees

• Credit sales to customers, or

• Business loan guarantees

As such the loan to your entity might be deemed a non-business loan and limited as a short-term capital loss.

Let’s not forget that you must also impute interest expense to the entity, and then subsequently pick up interest income on your individual tax return (Form 1040). Issuing a 1099-INT from the business to yourself seems silly, but true!

However, another situation might arise where you are partnering with someone else, and let’s assume you have all the money for startup funding. Recall the golden rule where the person with the gold makes the rules. As such, you might want to consider your funding as a loan to the business or real estate venture. This allows you to do two things; you can take money out of the venture ahead of others as a loan payment (return of capital) and you can execute a personal guarantee from your other partner collateralizing the loan.

You can also convert your loan into additional equity. For example, you are a 50% owner and lend the business $100,000. Things are going great; however, the entity does not have the cash to pay you back since all the cash is being re-invested back into the venture. You might have a provision within the loan agreements that allows you to convert the debt into equity.

We talked more about this myriad of possibilities when partnering with others, including adding partners in a previous section. Check it out!