Strategies for Entrepreneurs: How to Diversify Outside of Your Business

A group of male and female coworkers sit at a large office table under bright lights and discuss meeting topics.

Ask any entrepreneur about their investment plan and they'll likely say everything they have is tied up in the business. It’s natural—and even necessary—to be passionate about the fledgling enterprise you have created. But that drive to succeed can also leave entrepreneurs blind to a dangerous investment consequence: under-diversification.

Concentrating all or most of your money in the business—a single company in a single industry—heightens your exposure to risk and breaks the cardinal rule of investing: By diversifying, you help improve the chances that losses in one part of your portfolio will be offset by gains in another. Recognizing that risk, as well as the business’s role in your overall investment plan, is the first step toward building a more stable investment outlook.

Think Through Your Objectives

Taking money out of the business to fund other investment opportunities is one way to address the diversification challenge. However, determining the best method for extracting cash will require business owners to think through many issues, not the least of which is how the business has been organized, (e.g., as a sole proprietorship, a limited liability company (LLC), a partnership, etc.). Do it wrong and you’ll run the risk of upsetting business partners, or worse, the IRS.

Naturally, before you access cash from the business, you’ll need to consider your short- and long-term uses for the money. If your goal is to create a steady source of income, your approach may be very different than if you are seeking funding sources for your retirement.

That said, here are some accessible, tax-friendly ways for entrepreneurs to turn part of their investment in their business into a liquid asset.

Five Liquidity Options

1. Compensation. Putting yourself on the payroll provides a steady stream of cash, which you have the discretion of investing as you see fit. How much you pay yourself is a complex question that only you can answer. Should you take just enough to cover basic monthly living expenses? Should you get paid what you are fully worth in the open job market?

In terms of taxation, your business’s legal structure will have a direct bearing on how the IRS treats your compensation. For instance, with a sole proprietorship or partnership, you avoid double taxation as the IRS treats business profits and personal income the same.

2. Loan repayment. If you've loaned money to the business, document the transaction in a promissory note and set up a schedule for repayment. Putting money into the business is a very common way to fund start-up costs, but be conscientious about maintaining separate business and personal records of the transaction(s) and keep a thorough paper trail.

From a tax perspective, it is important to clearly document the transaction as a loan to be repaid, not as equity—meaning it is a contribution to the business which requires no repayment.

3. Borrow. Another common method for creating liquidity is to withdraw cash from the business in the form of a loan. While borrowing money is a simple and convenient solution for small business owners, it can also lead to tax woes if not done properly. If there is any reason for the IRS to question whether the withdrawal is, in fact, a loan, it can treat the loan as dividend income or as compensation from the business and tax it accordingly. To avoid this mischaracterization:

  • Document the transaction with care, including a promissory note, and a repayment schedule.
  • Be sure the loan bears interest at a rate that at least matches the current “applicable federal rate.”
  • Include the loan in the business’s accounting/financial records
  • Make repayments as indicated in the promissory note.

4. Benefits. Consider setting up a benefits plan that would allow you and your employees to take a portion of taxable compensation and put it toward nontaxable benefits such as health insurance, life insurance, disability insurance, dependent care, etc. These perks can be viewed as “cash equivalents” that are deductible to the business and not taxable to you.

Similarly, consider setting up a qualified retirement plan. Retirement plans can be an effective way to attract and keep loyal employees while helping owners to diversify their assets in a tax-advantaged way.

5. Outright liquidation. Certainly the ultimate liquidity strategy, there is no denying the finality of selling the business. And with such a weighty decision comes a tsunami of personal, legal, and financial issues to grapple with. If you, like many business owners, decide that your long-term goal is to keep both your personal wealth and the business in the family, there are many strategies to help you do just that while keeping a check on taxes. Briefly:

  • Private annuity sale—Under this arrangement the owner can transfer the business to a family member—thus removing the value of the business from his or her estate—in exchange for a lifetime stream of income.
  • Family Limited Partnerships (FLPs) – FLPs are used by business owners who want to gradually transfer income and equity in the business to children or other family members, retain control over the business, while reducing his or her gift and estate tax liability.

Note that these are complex planning structures with many legal and tax considerations not mentioned here. Please consult with the appropriate planning professional(s) before taking action.

Seek Guidance From Professionals

Regardless of the approach to accessing cash from your business, your first strategy should be to consult with your accountant, tax professional, or business advisor who can help you decide when and how to proceed. Such a professional can also advise you on how best to structure your non-business assets.

For instance, if your business is in the early start-up stage, any money available for outside investment might best be directed toward more conservative assets. The more established your business, the more risk you may potentially be able to take in your non-business portfolio.

The views expressed by the author are not necessarily those of Fifth Third Bank and are solely the opinions of the author. This article is for informational purposes only. It does not constitute the rendering of legal, accounting, or other professional services by Fifth Third Bank or any of their subsidiaries or affiliates, and are provided without any warranty whatsoever.