I put my own money in to cover a business bill, or I lent the business money — is that a loan or my equity, and how do I record it?

What decides whether the money is a loan or equity?

The facts decide, not the name of the account. Federal tax law frames the question for a corporation as whether a debtor-creditor relationship or a corporation-shareholder relationship exists, judged on the facts of each case. The statute lists factors that the Treasury regulations may include, among others:

• whether there is a written, unconditional promise to repay a fixed sum on demand or on a set date, with a fixed interest rate
• whether the amount ranks behind, or ahead of, the corporation's other debts
• the corporation's ratio of debt to equity
• whether the amount can be converted into stock
• how closely each person's share of the advance matches their share of the stock

So look at your own advance with those questions. Is there a written promise with a due date and interest? Do you get paid back only after everyone else? Did each owner put in money in proportion to their shares? The statute lists these factors but does not say which way any of them points, and neither do the other sources cited here. Weighing them for your advance is a judgment to make with your tax adviser. The statute also authorises the Secretary to prescribe regulations that may treat an interest as in part stock and in part indebtedness.

Timing matters. The characterization a corporation gives an interest when it issues it binds the corporation and the people who hold the interest, but it does not bind the IRS. Except as provided in regulations, it also does not bind a holder who discloses on their return that they are treating the interest inconsistently. Decide when the money comes in, record it that way, and make sure the facts back the label.

Two more IRS points apply to S corporations. A shareholder gets debt basis only for money they personally lent to the corporation, and guaranteeing the corporation's bank loan does not count. And where a shareholder says they contributed or lent substantial funds, the IRS says to consider whether they had the financial means to do so. Keep the bank records that show the money came from you.

Those factors come from the rules for corporations. If you run a sole proprietorship, there is no separate business to owe you anything (see the section on business forms). If you run a partnership or a multi-member LLC, work through the same questions and agree the answer with your tax adviser before you label an advance a loan.

What paperwork makes a loan hold up?

A loan you can support has three things behind it.

1. Written terms. A note signed by the business and the lender that states the amount, when it must be repaid (on demand or by a date), and the interest rate. Those are the features in the first statutory factor above.
2. Evidence of agreement. The note is signed by someone with authority to borrow for the business. If there are other owners, they know about it and have approved it.
3. Behaviour that matches. The business pays interest and principal as the note says, and the books show those payments against the lender's own account.

Undocumented or non-standard terms, and pricing well away from market rates, are common red flags in dealings between related parties. A balance called a loan that has no terms and has never had a payment is exactly that red flag. If financial statements based on your books go to a lender or investor, do not say or imply the loan was made on arm's-length terms unless you can prove it.

Drafting the note itself is a job for a lawyer. What your books need is a copy of the signed note, filed with the entry that recorded the money coming in.

Does the business have to charge interest on the loan?

It depends on who lent the money and on the rate. The federal below-market loan rules in section 7872 of the tax code apply to several kinds of loan, including:

• gift loans
• any below-market loan, direct or indirect, between a corporation and one of its shareholders
• any below-market loan where one of the main purposes of the interest arrangement is to avoid federal tax

If a partner lent to a partnership, or one company lent to an affiliate under the same control, the listed categories do not name your case. The statute also reaches, to the extent provided in regulations, any other below-market loan whose interest arrangements have a significant effect on any federal tax liability of the lender or the borrower. The cited sources do not settle whether that reaches your loan.

A demand loan is below-market when its interest rate is less than the applicable federal rate (AFR). A term loan is below-market when the amount loaned exceeds the present value of all payments due under the loan. For a demand loan, the AFR is the federal short-term rate for the period being measured, compounded semiannually. For a term loan, it is the AFR in effect on the day the loan was made, compounded semiannually. The IRS publishes these rates every month as revenue rulings.

For a below-market loan to which section 7872 applies and which is a gift loan or a demand loan, the interest not charged (the forgone interest) is treated as transferred from the lender to the borrower and retransferred by the borrower to the lender as interest. For loans between a corporation and a shareholder, there is an exception: the section does not apply on any day when the total loans outstanding between the two are $10,000 or less. That exception does not apply if avoiding federal tax is one of the main purposes of the interest arrangement.

In practice, write a rate into the note, check it against the current IRS table with your tax preparer when you set it, and record interest as it accrues. Working out any imputed interest and its effect on your personal taxes is a matter for your tax preparer.

How does your business form change the accounts?

Sole proprietorship. A sole proprietorship is not a separate business entity, so your business assets and debts are not separate from your personal ones. You cannot owe yourself money. What you put in goes to your owner's capital account, which holds the owner's investment in the business plus its earnings, less draws.

Partnership or multi-member LLC. Each partner has a separate account for their investment, distributions and share of gains and losses. Cash a partner invests is recorded as a debit to cash and a credit to that partner's capital account. Money a partner takes out is a credit to cash and a debit to that partner's capital account, or it goes to a drawing account first and is moved to capital later. A loan from a partner is recorded outside the capital accounts, in a liability account named for that partner.

Corporation, including an S corporation. A corporation is a legal entity separate from its owners. Stockholders' equity is the owners' leftover interest in the company's assets once liabilities are subtracted. Its accounts include common stock and additional paid-in capital. A shareholder loan is a liability, so it belongs among the liabilities. Money contributed as equity goes to an equity account such as additional paid-in capital.

Single-member LLC. Before you record a loan from the member, settle with your tax adviser whether to treat the LLC like a sole proprietorship or like a separate entity.

How do you record the money in and the money out?

Say Dana, an owner, puts 6,000.00 into the business account. Here is the same deposit recorded both ways, with the matching money going back out. The figures are invented.

As a loan. Coming in:

Interest accrues at the rate in the note:

The business repays the loan with interest:

While the loan is open, the balance sheet shows a 6,000.00 debt owed to Dana, and Dana's ownership stake has not changed. Only the interest is a cost. Repaying the principal just clears the debt.

As equity. Coming in (sole proprietorship or partnership; a corporation would credit an equity account such as additional paid-in capital):

Going back out (sole proprietorship or partnership):

Here nothing is ever owed. The 6,000.00 raised Dana's stake, and taking it out reduces that stake. There is no interest, and the payment out is never a business cost. In a corporation, the payment out is a distribution to shareholders, not a loan repayment. Ask your accountant which equity account your corporation records it in.

The two treatments split the moment money goes back out. A repayment has to hit the loan account, and a draw or distribution has to hit equity. Mixing them leaves a balance that means nothing. How to record your ongoing draws and deposits is covered in the guide on money you take out of the business and money you put in.

What if you paid a business bill from your personal account?

This is the case most often left out of the books entirely, because no money ever passed through the business account. Business activity has to be recorded separately from the owner's personal activity, so the bill still belongs in the business books. Record the cost, and record your side of it under the characterization you chose.

Dana pays an 800.00 repair invoice from a personal card and the owners agree it is a loan. If the bill was never entered in the books:

If the bill was already entered in accounts payable, the repair cost is already recorded. Dana's payment settles the payable instead of adding a second expense:

If it is a contribution instead, credit Owner's capital – Dana (or the corporation's paid-in capital account) for 800.00. Either way, keep the invoice and proof of your personal payment with the entry. If the loan route applies, the 800.00 belongs under the same signed terms as any other advance. Getting costs you paid personally before the business opened into the books is a separate task.

What if a relative or another company you own put the money in?

The decision is the same, and the lender must stay identifiable in the books. Related parties include affiliates, other companies under common control, owners, managers and their families. Loans to or from related parties carry a risk of conflicts of interest and can distort how fairly the financial statements present the business, so document these loans at least as carefully as your own.

• Give each lender its own account. Use one liability account per lender, such as "Loan payable – Chris Lee" or "Due to Northside Holdings LLC". Never lump a lender in with the owner's accounts. Business records should be kept separate from the owners' records and from those of any other business. Where related-party disclosures are prepared, they cover the amounts due to or from related parties and how those amounts will be settled.
• Relatives. A below-market loan is a "gift loan" when the interest not charged is in the nature of a gift, and the section 7872 rules apply to gift loans. For a gift loan directly between individuals, the section does not apply on any day the total outstanding loans between them do not exceed $10,000. That exception does not apply to a gift loan directly attributable to buying or carrying income-producing assets. The cited sources do not settle whether a relative's loan to your business is a loan directly between individuals. A family loan needs the same signed note and stated rate as any other loan. If a relative's money is meant to buy them a stake, that changes who owns the business, so settle it with your lawyer before recording anything.
• Another business you control. Record the advance in both sets of books: a receivable in the company that sent the money and a payable in the company that received it, each named for the other company.

What if only one of several owners put money in?

The characterization then affects the other owners. In a sole proprietorship or partnership, a contribution recorded as equity raises that owner's capital account. In a corporation, a shareholder's contribution is credited to paid-in capital, not to a per-owner capital account. A loan creates a debt the business owes to that owner. Agree the treatment in writing among all the owners before recording it, and keep each owner's capital account (where your form has one) and any loan account separate.

What if the books and the paperwork already disagree?

Fix the mismatch as soon as you find it. Don't wait for year end.

• "Loan" in the books, no note, no payments. Decide with the other owners and your tax adviser whether it really is a debt. If it is, sign a note now, dated today, that states the terms, and start making payments under it. Never backdate a note. If it is not a debt, move the balance to the contributor's capital or paid-in capital account with a dated entry that explains why.
• Note exists, but the money was recorded as equity or as income. Reclassify it to that lender's loan account with a correcting entry that references the signed note.
• S corporation repaying a shareholder loan. Check with your tax preparer before repaying a shareholder loan that losses have already been claimed against. Part or all of the repayment of a reduced-basis debt is taxable to the shareholder.

Remember that a corporation's characterization at issuance binds the corporation and the holders, except (as provided in regulations) a holder who discloses inconsistent treatment on their return. Changing your mind later is not a bookkeeping fix, so get advice before you reclassify an old corporate balance.

Which recording mistakes undermine the loan-or-equity decision?

• Parking the money in suspense or "ask my accountant". The decision then gets made at year end without the records from the time that would have supported it.
• Calling it a loan with no terms and no payments. The books then claim something the facts do not support.
• Pooling balances. Mixing owner loans with owner equity, or several owners and relatives in one account, leaves a balance nobody can interpret or repay.
• Recording a loan repayment as an expense. That overstates the period's costs and leaves a debt on the balance sheet that has already been paid. Only interest is a cost.

If the money you received came from a bank or outside lender rather than an owner, see the guide on recording loan money that lands in your business bank account.