The Right Way to Make a Personal Loan to Your Business

If you’re the only owner of your business—whether as a sole proprietor, as a single-member LLC, or as the sole shareholder of a corporation—from time to time, you’ll probably find yourself making a personal loan to your business.

You don’t really think of it as a loan, though. Because you’re the only owner, you just move money from your personal bank account to the business’s account. You make a mental note of this, and you pay yourself back when you can.

This, however, is a bad idea. It is especially bad if your business is an LLC or a corporation. If you fail to document the loan and treat it as a formal loan, you could lose the legal liability protection afforded by these business formats.

There is a correct way to document the money you lend to yourself to fund your business. Fortunately, it’s not too hard. Read on to find out how.

Borrowing Money from Yourself as a Sole Proprietor

If you’re a sole proprietor, simply moving money from your personal bank account to your business account might be OK. Documenting a personal loan is good accounting practice, but there are little to no tax consequences if you don’t.

As a sole proprietor, the tax authorities treat you and your business as the same entity. Lending money to your own business just means you’re transferring money from one bank account fully owned by you to another bank account fully owned by you.

To keep your business’s books straight, you could record this transfer as a personal loan or as additional owner’s equity. Either way, if a governmental tax authority asks about the money, you should have enough paper trail to be able to show that the money is not income you earned from third parties. It’s merely money you’ve moved from one account to another. So, you don’t owe taxes on the loan.

Borrowing Money from Yourself as a Single Member LLC or Sole Shareholder of a Corporation

If your business is an LLC or a corporation, you’ll have to treat the loan more formally. One of the biggest reasons for setting up an LLC or corporation is to separate your business liability from your personal assets. To do so, you must treat the LLC or corporation as an entity different from yourself—i.e., as another “person.”

Ideally, when you lend money to a friend, you should at least have some sort of written IOU to document the loan. You should do the same when you lend money to your LLC or corporation. If you don’t, then the courts might say that since you don’t treat the LLC or corporation as a different “person,” then the law shouldn’t have to either. You might end up with your corporate veil pierced. Then, all your personal assets would be on the line for your business’s debts.

In addition to limitation of liability, you might have tax issues as well if you fail to document the money you lend to your own business. A loan is typically not taxed as income, but a forgiven loan is usually counted as income.

If you’re a single member LLC taking advantage of pass-through taxes, this might matter less. But if you’re a corporation and you forgive that loan, your corporation might end up owing taxes on that loan. It’s just easier to document your loan and pay back that loan according to the steps outlined in the loan.

How to Write a Personal Loan to Your Business

Fortunately, it’s not that hard to document a personal loan. Technically, the loan is called a promissory note. The note is easy to write up.

Here are the information you should include:

• Lender and address
• Borrower and address
• Date of the promissory note
• Amount borrowed
• Fair and reasonable interest rate (if any)
• Date first installment repayment is due
• Date last payment (or full repayment if there are no installment payments) is due

You can, but don’t have to, add:

• Nonpayment penalty
• Prepayment penalty
• Collateral
• Dispute resolution procedure

You’ll need to sign the note as yourself on the lender’s side. You’ll also sign as the managing member of your LLC or the CEO of your corporation on the borrower’s side.

Example Promissory Note

For your convenience, here’s what a promissory note could look like. This form is based on research and common sense, but we haven’t examined all the laws related to lending money to make sure it is 100% fail-safe. You’re free to copy this example and use it for your business, but you do so at your own risk.

If you have a letterhead for your business, put the promissory note on your letterhead to make it more official. When the loan is paid off, make a note of it as the business owner and mark it paid. This way, you can keep a clear record of the loan.

Should You Pay Yourself Interest on the Loan?

Formal loans tend to come with an interest payment. But do loans absolutely have to include an interest payment? The answer from research is a little conflicting, but it seems that loans do not always have to have interest payments. However, we suggest that you do include an interest payment in your personal loan, just to be safe.

Be careful to not make the interest too high, or you might run into trouble with usury laws.

Interest is typically deductible as an expense for the business. But it is typically taxable as income for you, personally. This creates some extra work, but there’s a way to avoid it.

If you look closely at the example promissory note above, nothing says you can’t borrow more from yourself to repay the loan.

For instance, right before the first repayment and first interest payment to the loan are due, Kibbles Shack decides it wants to repay $200 out of the $1,000 loan. Kibbles Shack would still owe Aspen $800 for which interest payments will have to be paid every month.

But, instead of continuing with the note, Kibbles Shack could simply borrow $800 from Aspen, as a new loan. Kibbles Shack then pays Aspen back the full $1,000 that was borrowed earlier. The payment includes the $200 Kibbles Shack was going to pay Aspen. It also includes the $800 Kibbles Shack just borrowed from Aspen.

Now, Kibbles Shack will have 6 more months to pay Aspen back the $800 without having to worry about an interest payment.

The Personal Loan Documentation is Important to Keep Up

If you have business partners or investors, it’s pretty intuitive that if one or more of you make a personal loan to start the business, you’ll want that documented on paper. However, if you’re the sole owner of your business and just want to fund your new business with your own money or keep your business going, you might think that documenting this loan is a time-wasting silly formality. But it’s not.

One of the most common ways a one-person owned small business loses the liability protection as an LLC or corporation is to borrow money from yourself without proper documentation. Yet, this can be so easily avoided.

All you have to do is to set up a template and always use this template to lend money to your own business. Keeping up the paperwork just means calendaring the time the loan is due and write up another loan. It’ll take you probably less than 10 minutes, but it might save your personal assets from future business liabilities. In the long run, it’s worth doing.

Interested in starting and running a small business? Here’s the beginning of our step-by-step guide: What to do right after getting that great business idea.

DISCLAIMER: This article does not constitute legal or accounting advice. Instead, it contains general information. The information gives you the background you’ll need to hit the ground running when you do go get advice from a lawyer or accountant. Only lawyers and accountants properly licensed in your state/country are qualified to give you legal or accounting advice.