Buying a business is an investment that takes time, money, and research. There are many different financing options available to purchase a business, but these can have profound tax implications for you, unlike personal investment decisions.
What is Business Financing?
When you buy a business, you can choose from several different forms of financing. Call it cash, call it debt, call it equity. “financing” covers everything from a handshake agreement to a mortgage.
It is called debt financing because it does the businesses you buy or sell indebted to you. It is a contractual agreement outlining whom, when, and how much of the loan must be repaid. In other words, it’s a financial liability. There are many types of debt financing available to businesses
This is also called capital investment or risk capital because it involves an exchange of cash for ownership in a business. In other words, it is an investment or a personal liability. You become a part-owner of the business.
Numerous tax concerns must be analyzed when you plan to buy or sell a business. These considerations should be examined before you make your decision for one form of financing over another.
Income Tax Concerns.
There are two taxes to consider for debt financing. First, you must consider the tax ramifications of payments made on loan. The payments can be interest, salaries, or other sums of money owed to you by the business. The second tax concern is that of accrual income and deductions. Your accountant should provide you with detailed financial records and explanations of these concerns before your financing decision is made.
Like most business transactions, debt financing will increase taxable income. This is often described as an increase in “gross income.” Your accountant can calculate your gross income for you.
When you buy a business, you will usually have to pay for some purchase price with cash. The remaining portion of the purchase price will be financed by the seller (or lender) through a loan or line of credit. The loan payments are deductible for tax purposes. The expenses associated with the loan will be added to the business’s expense base, increasing the business’s cash flow.
Mezzanine capital financing is a popular form of debt financing used to buy a business. Mezzanine financing is also commonly referred to as “working capital” and “small business loan.” The term mezzanine is borrowed from the world of high finance.
It refers to the middle tier or level in a three-tiered capital structure. Mezzanine financing sits between equity investments and first-tier debt in the capital structure.
Mezzanine financing is a hybrid form of financing that benefits debt and equity capital. Interest paid on mezzanine loans is tax-deductible, similar to the interest payments on traditional debt. The Internal Revenue Service (IRS) is likely to look closely at the loan arrangements between you and your buying or selling business.
Funding From Family and Friends.
Often the best financing option available to you will be from family or friends. This option, however, may come with some significant tax concerns of its own. While the amount of interest paid on loan may be deductible, interest paid on a personal loan is not deductible at all. In addition, the tax rules regarding loans to yourself also apply to loans made by family and friends (unless otherwise exempt). For more information on basics of financing a business visit investopedia.
In conclusion, before deciding on a form of financing, you should weigh the risks involved with each type of financing. There are many ways to finance a business, and you should carefully research your options to make an informed choice.