Guide to Tax Implications of Financing Options

If your business needs money, you have different ways to raise it. You can take in investors (equity financing), borrow it (debt financing), win contests or grants, or simply have people give you money (gifts). Each of these options presents different practicalities for your business; they also have different tax consequences. Here’s a guide on how to treat your funding from a tax perspective.

Equity financing

Raising capital by seeking new investors—family, friends, strangers, other businesses—does not present any immediate tax consequences. The cash and/or property is a contribution to the capital of the business.

Payments by corporations to investors in the form of dividends, based on earnings and profits (E&P), are not deductible by the corporation. Investors pay tax on dividends, usually with favorable tax rates (e.g., zero, 15%, or 20%). Investors in other types of entities, such as limited liability companies, are also usually taxed on distributions.

Debt financing

Borrowing money generally obligates you to repay the funds, plus interest. In some cases, there may be deferment for repayment. Interest rates may be low, such as through various SBA loan programs, or high, such as credit card repayment.

• Repayment of principal is never tax deductible.
• Payment of interest is tax deductible. However, there is a limit on deducting business interest that may cap your annual write-off. If a lender gives more time to make payments, interest does not become deductible until it’s actually paid. (The SBA had allowed some SBA loans obtained prior to the pandemic to delay repayment but did not provide any special tax relief here.)
• Cancellation of debt, such as a reduction in principal, usually is taxable income (but see exceptions under COVID-19 programs below).

COVID-19 programs

The federal government has an array of financing programs to assist small businesses suffering as a result of closures, cutbacks, and other adverse actions because of COVID-19. The tax treatment varies with the financing program.

• Paycheck Protection Program (PPP) loans. The receipt proceeds from the original program or “second draw” loans is not taxable. Loan forgiveness is tax free and you can still deduct expenses covered by this under usual tax rules. Amounts not forgiven that are repaid have the same tax treatment as other debt financing discussed above (i.e., deduction for interest payments but not principal).
• Economic Injury Disaster Loans (EIDLs). The receipt of loan proceeds is not taxable. There is no loan forgiveness under this program, so repayments follow usual debt-financing rules. However, the $10,000 advance under the initial program (Spring 2020) as well as the $10,000 advance under the new Targeted EIDLs for small businesses in underserved areas are tax free.
• Shuttered Venue Operators Grants (SVOGs). These are nontaxable grants. They do not have to be repaid and are tax free. Applications for these grants can begin in early April 2021.
• Restaurant Revitalization Fund grants. These are also nontaxable grants to small and independent restaurants.

Most of the programs are handled through the SBA; check for details.

There may also be state and local programs to help your business. What they are, and what tax treatment results, depends on the terms of the program and your location.

Crowdfunding

If you raise money through a crowdfunding platform such as Kickstarter or Indiegogo, the tax implications depend on how you solicit funds. The funds are not taxable if you solicit them with no quid pro quo (people just give you money with no expectation of receiving anything in return), as is typical on GoFundMe; this is a gift. But if there are other motives or actions, then other tax results ensue:

• If they are funds from investors, they are contributions to capital (see equity financing above). This is referred to as equity crowdfunding.
• If you promise to repay the funds, this is a loan (see debt financing, above). It’s not taxable to the business.
• If the money is received in exchange for services rendered, this creates taxable income.

Contests and grants

There are numerous contests and grant programs annually for the benefit of small businesses (e.g., FedEx). What’s received does not have to be repaid. But the money or other property and value of services received usually is taxable. In addition to prizes and grants from the private sector, most state and local grants to businesses are includible in gross income.

But there are exceptions for certain federal grants programs, such as:

• COVID-19-related grants explained earlier.
• Indian financing grants, which are made under title IV of the Indian Financing Act of 1974 to Native Americans to expand “profit-making Indian-owned economic enterprises on or near reservations.”

Final thought

The content here reflects federal tax rules. Be sure to check the applicable rules in your state, which may differ from federal tax treatment. When in doubt, consult with a tax professional.

Image: Depositphotos

This article, "Guide to Tax Implications of Financing Options" was first published on Small Business Trends