What should you do if a family member approaches you asking for a business loan? Whether it's an adult child with a great idea for a tech startup or a cousin with an already-established business who's unable to find a traditional bank loan, you'll need to be careful.
First and foremost, family loans must be structured properly. Otherwise, you and the borrower could invite IRS scrutiny and harm the borrowing business's ability to raise additional capital. For this reason, discuss the loan with a professional tax advisor before saying "yes." Here are some important points to keep in mind:
1. Borrowers must pay adequate interest. Loans from family members should generally be treated like loans from outside investors or lenders. Loans should carry interest at no less than IRS-prescribed rates. For multi-year loans, the rate is set monthly by the IRS based on the number of years in the note. Demand loans — which have no stated term and thus are payable on demand — have a varying monthly interest rate.
2. Loan agreements should be legally binding. You'll need to ensure that any family loan agreement is legally binding (which means you should consult an attorney). Also establish a pattern of regular repayments. This information must be included in your company's financial reports and company meeting minutes.
3. Ownership matters. What happens if you're a shareholder of your borrower's business? If the interest rate you charge is less than the IRS-prescribed rate, you must treat the interest as a dividend or distribution. But if you have no ownership in the business, you can treat the interest as income with an offsetting interest expense instead of a capital contribution and distribution.
4. Debt can easily trip up borrowers. For tax purposes you may structure a transaction with a family member as an outright gift or as a loan. But your family member should be wary of borrowing too much. It can signal to bankers and potential investors that the business is financially unstable. In most cases, banks insist that any outside loans be subordinated to the bank's senior debt.
Businesses that are thinly capitalized because most of their funds are from loans rather than from capital contributions can send bankers and potential investors packing. In addition, if the IRS considers a business's debt to be high compared with its capital contributions, it may recharacterize the debt as equity, resulting in a disallowance of interest expense and higher corporate taxes. Further, treatment of payments to shareholders may be reclassified as dividends, possibly resulting in higher individual income taxes.
5. You shouldn't risk your own company. Although it's important to support family members, don't make business loans that could potentially destabilize your own company. Work with objective professional advisors to determine, among other details, how much you can afford to lend and how likely your family member is to repay any loan you make.
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