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Putting Money Into a Small Business

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"I'm starting a small business with a good friend of mine, and we've just formed a limited liability company (LLC). We're dividing everything up 50/50 between us, but our accountant is telling us to put all our money into the LLC in the form of loans. Why is she telling us to do that?"

Generally, there are two ways (and only two ways) that you can put money into a business if you are one of the owners. Either:

— you make a loan to the business; or

— you make an "equity investment" in the business.

A lot of people use the term "investment" to cover both of these concepts, but that's not correct. Loans and equity investments are two very different things, and are treated very differently for legal and tax purposes.

Loans

When you make a loan to a corporation or LLC:

— the corporation or LLC is legally obligated to pay it back to you on a certain date, or in installments over time, with interest on the outstanding balance of the loan;

— the corporation or LLC can deduct payments of interest (but not principal) on your loan;

— loans to a corporation or LLC need not be made "pro rata" — if you lend money to the company, but your partner does not, you remain 50/50 owners of the business;

— unless you are also a director, officer or manager of the corporation or LLC, as a lender you have no right to make business decisions or judgments as long as you are receiving your principal and interest payments on time; and

— if the company fails, people who have made loans to the company get their money back before anyone else does.

That's the basic tradeoff with loans: You have at least some protection if the business should fail (there's no guarantee that the company will have enough assets to pay your debt, but you will have "first call" on whatever assets the company owns when it fails), but you don't get a say in running the business.

Equity Investments

Whenever you put money into a company in exchange for a percentage of the business profits and losses (a partnership interest in a partnership, shares of stock in a corporation or a "membership interests" in an LLC), you are making an "equity investment" or "capital contribution."

When you make an equity investment in a corporation or LLC:

— you get to call the shots — equity owners get to elect the managers who run things, or appoint themselves to act as managers;

— the corporation or LLC is not obligated to repay your investment at any time — any payments the company may make to you as an investor (called "dividends" for a corporation, "distributions" for a partnership or LLC) are entirely at the discretion of the company's management;

— the corporation or LLC cannot deduct any distributions or dividends it pays to you;

— capital contributions to a corporation or LLC must be made "pro rata" — if you contribute capital to the company, but your partner does not (or, since you are 50/50, you make a greater investment than he does), you are no longer 50/50 owners of the business — your partner's ownership percentage is reduced, or "diluted," by the amount of your "excess" investment divided by the fair market value of the business;

— if the company should fail, you and your partner will have to wait until all of the company's creditors are paid in full before you split up whatever's left over.

That's the basic tradeoff with investments: Unlike a lender, you have no assurance you will ever get your money back (much less a return on your investment), but to compensate for that you are given the right to run the company so you can do everything possible to protect your investment.

In these troubled economic times, many entrepreneurs are putting their money into businesses as loans rather than equity investments.

The reasoning is obvious: Since in recessionary times there is a much greater likelihood of a business going "belly up," lenders are much more likely to get their money back than will equity investors when a business goes "belly up."

There are some risks involved, though, in lending money to a company you partially own:

— As a lender, your return is limited to the interest the company is obligated to pay you (although you can build in an "equity kicker" allowing you to collect a percentage of the company's monthly or quarterly profits as "additional interest" over the stated interest rate);

— If you load up your company with too much debt, there's a risk the IRS will reclassify your debt as "equity" and disallow your company's interest deductions; and

— If your company files for bankruptcy protection, the court may "subordinate" your loan, meaning you will have to wait until those creditors who are not also owners of the business are paid in full.

Cliff Ennico (cennico@legalcareer.com) is a syndicated columnist, author and former host of the PBS television series 'Money Hunt'. This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our Web page at www.creators.com.

COPYRIGHT 2009 CLIFFORD R. ENNICO.

DISTRIBUTED BY CREATORS SYNDICATE, INC.

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1 Comments | Post Comment
Cliff,

Good article. I'm a SCORE counselor and I will use this from time to time counseling some of our clients.

Paul
Comment: #1
Posted by: Paul Burri
Sat Feb 28, 2009 9:57 AM
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