Financing that you and your partner raise for your company is either recorded as equity or debt and may come from a number of income streams. Capital may come from your own money, from stock shares in the company you sell to investors, direct bank loans or loans from shareholders. Partners and investors share the risks, hoping they will pay off with greater returns.
Loans from shareholders offer another avenue you may take to raise capital. Those investors are called “partners in profit and risk.” Loans may either be covered by providing shares to the lenders or securing the loans with a debenture — an unsecured bond with a set maturity date that you pay off with interest. When you secure the loan with shares in the company, you may count that money as equity. If you offer a bond or other form of repayment, the investment is treated as debt.
When shareholders hold stock in your company, they retain a portion of the equity. They are part owners in a sense. When one of those investors makes a shareholder loan, his equity in your business does not increase. Instead, it’s treated as a loan from an individual to whom you must make a repayment. While you may count the funds as equity or capital, the shareholder who extends the loan carries the loan as debt.
Shareholder loans provide some tax benefits that an outright sale of stocks does not offer. You don’t have to pay taxes on the funds as you would if the money translated to increased equity of profit. By leaving the loan on your books, you enjoy tax-free principal repayments and the interest you pay is tax deductible. Shareholders making loans also enjoy tax benefits as they can write off the loan as debt instead of adding equity to their portfolios.
When one partner becomes insolvent, the other partner could be liable for all the debts incurred by the partnership. To avoid the risks inherent in a partnership, consider forming a shareholders' agreement with your partner, or developing a binding contract that spells out the terms of debt repayment and stock distribution. Regularly review your shareholder loans and your schedules of repayment with your partner to ensure agreements are being followed.
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