Often overlooked in the search for affordable funding are small business grants offered through nonprofits, government agencies and other sources. Small business grants offer a way for portable plant businesses to grow without having to worry about paying back the funds.
Local economic development agencies or small business development centers can aid in locating grant programs and similar funding opportunities. Grants.gov is an online database for grants available from government agencies.
Beware, however, everybody wants free capital, making finding and applying difficult – but rewarding.
An effective strategy for minimizing the cost of the funds needed may involve selling the business. An employee stock ownership plan (ESOP) is a tax-effective way to transfer ownership of a small, incorporated business to employees while raising the funds needed by the operation.
With this option, the business issues new shares of stock and sells them to the ESOP. The ESOP then borrows funds to buy the stock. The portable plant operation can use the proceeds from the stock sale to its own benefit – growth or expansion.
The business repays the loan by making tax-deductible contributions to the ESOP. The interest and principal on ESOP loans are tax-deductible which can reduce the number of pre-tax dollars needed to repay the principal by as much as 34 percent, depending on the operation’s tax bracket.
Unfortunately, the tax shield does not help with S corporations because they don’t pay corporate income taxes. Capital gains deferral, however, can make ESOPs attractive to these pass-through business entities.
Bootstrapping and self-funding
Every business owner should have at least some personal funds at risk to show potential lenders or investors they are committed to the success of the business. Still, tax laws can make self-funding a touchy – and complex – situation.
The most basic, affordable self-funding strategy, called “bootstrapping,” means using personal or family funds to finance the business. Offsetting the convenience of bootstrapping is the necessity for the owner or shareholders to often give up equity in the business.
What’s more, whenever a loan is made between related entities, or when a shareholder makes a loan to his or her incorporated business, it must be at “arm’s length.” Tax laws require a fair-market rate of interest be included. If not, the IRS will step in and make adjustments to the below-market interest rate transaction in order to properly reflect “imputed” interest.
Borrowers beware
Dealing with an economical, but unfamiliar lender isn’t always trouble-free. A loan agreement might contain a provision requiring immediate repayment of the loan if the borrower misses several payments or fails to maintain certain debt service coverage.
Some lenders want delayed payments made up in a single payment, some will modify and extend the loan with minimal paperwork, while others treat it as refinancing – complete with the costs associated with refinancing. Every borrower should have a clear picture of what the lender intends to do at the end of the loan period.
And, speaking of loan terms, every borrower should match the term of a loan to the life of the item to be financed. If the financing is for equipment, the loan shouldn’t be longer than the expected life of that equipment.
On a similar note, a fixed interest rate stays the same throughout the term of the loan while business loan rates can fluctuate, making them more expensive.
After funds have been obtained from an economic source at a favorable cost, it doesn’t mean the interest is automatically tax deductible. There is something called the “tracing rule,” where interest is traced to its use to determine if it is deductible.
Suppose a business borrows money but only a portion is used to purchase needed equipment. The balance of the borrowed funds goes to a key employee or even the owner to purchase a personal vehicle.
Obviously, the interest on the borrowed funds used for equipment, supplies or other business expenses are deductible. The interest on the portion of those borrowed funds distributed as a loan or bonus is not tax deductible by the borrowing business.
Every operator seeking to borrow money faces challenges such as where funding is available and at what interest rate? What is the total cost including fees? Is the funding good for an extended period, or can payment be demanded early? Guidance from a professional adviser may be necessary.
Related: Choosing whether to repair or replace equipment
Mark E. Battersby is a freelance writer who specializes in taxes and finance.