Small business owners often make the mistake of “co-mingling” business and personal finances. For example, small business owners frequently will use a single credit card to make both personal and business purchases. Or, a small business owner might pay a personal debt with a business bank account check, or vice versa. While these transactions may not be fatal to preserving the separate legal entity status of a corporation or limited liability company (aka “Small Business Entity” or “SBE”), co-mingling monies and expenses can weaken the asset protection afforded by a SBE and cause accounting challenges.
The better way to handle personal and small business finances is to keep the two separate in every way. That means personal debts are only paid with personal funds, and business debts are paid only with funds belonging to the SBE. Separate bank accounts, credit card accounts, lines of credit, accounting systems, etc. are maintained. While an owner of a SBE may be required to personally guarantee business debts, the debt should be in the name of and owed by the SBE, not its owners.
Loans & Equity Investments
When a SBE is in need of funds from its owners, there are two ways that the owners can fund the SBE. Either the owners can make a loan to the SBE or the owners can make a capital or equity investment in the SBE. The two (loans vs. contributions) are very different, and there are significant legal and tax consequences as to how loans are treated versus equity investments. See below.
When an owner makes a loan to a SBE, there is a legal obligation that the loan be repaid at some point in time with interest. Generally speaking, the interest payments will be taxed as income for the owner and deductible interest for the SBE. How and when loans can be made by the owners will often be governed by the SBE’s by-laws or operating agreement. If the SBE fails, loans are repaid first, before equity owners receive any return on their investments.
When an owner of a SBE puts money into the company in exchange for ownership or for a percentage of the profits or losses, those funds are characterized as an “equity investment” or “capital contribution.” Unlike a loan, absent some other agreement, there is no obligation that the SBE must repay a capital contribution. Usually, the board of directors of a corporation or the managers of an LLC have the right to determine how and when capital contributions will be repaid to the owners. Again, however, how and when capital contributions will be repaid will often be governed by the SBE’s by-laws, buy-sell agreement or operating agreement. Also, there are federal tax code provisions that determine how the repayment of capital contributions (called “distributions”) may be treated for tax purposes, and those tax rules can be complicated, requiring professional guidance from a CPA or other tax professional.
In a separate article, we have written about “phantom income,” which is a term that describes taxation of profits allocated to an owner in an amount exceeding the actual cash distributions received by that owner in any given tax year. So, for example, an owner of a SBE may be allocated $10,000 of profits one tax year but only receive $2,000 of distributions, resulting in $8,000 of “phantom income” that must be reported on the owner’s personal income tax return. A good operating agreement or buy-sell agreement can require minimum mandatory distributions to minimize the negative effects of “phantom income.”
Please read our other articles to learn more.