Family Businesses Must Handle Financing With Care

Does your family business need a cash infusion to maintain operations or pursue growth opportunities? Common sources of family-business financing include personal savings, credit cards, home equity loans, second mortgages and personal loans. These loans sometimes originate from relatives not directly involved in the business.

Intrafamily loans can contribute to your business's success and strengthen your family's financial position. However, they must be approached carefully. If not properly managed, these financial arrangements can strain relationships and put both the business and your family's finances at risk. Here's how to manage debt responsibly and avoid common pitfalls.

Follow Best Practices

Consider the following five strategies to guide your business's debt management efforts:

1. ‍Coordinate with family stakeholders. Plan financing arrangements with other relatives involved in the company. This includes the type of financing, repayment schedules and realistic expected returns from the business.‍
2. Put it in writing. If you borrow from a family member, formalize it with a written agreement to ensure the repayment schedule is understood. Formal loan documents help secure tax benefits and to promote family harmony.‍
3. Compare lending options. Evaluate the costs and risks of various loan options. For example, when you borrow against a credit card, rates are usually higher than on a home equity loan, but you don't risk foreclosure on your property.‍
4. Investigate borrowing under the company's name. Compared to intrafamily loans, conventional business loans usually have higher rates and require more paperwork and more rigid qualifications. But they help establish business credit, making it easier to borrow in the future and eliminating strain on the family's finances. (See "When to Consider External Financing Options" at right.)‍
5. Separate business and family finances. If you borrow from traditional lenders or a government agency, such as the Small Business Administration, keep in mind that they insist that business and family finances be kept separate. The IRS also demands this. (See "Beware of Intrafamily Loan Tax Consequences" below.)

Like external financing sources, family lenders expect a return on their money. This could come in the form of increased equity in the company. Or it could involve principal and interest payments from the business to the family member. In either case, keep written documentation. This protects the company at tax time and helps alleviate questions about future payments as the business expands beyond the family. In addition, documentation is important if you seek additional funds from traditional lenders or the government.

Proactively Address Intrafamily Loan Problems

If your family business thrives, there shouldn't be any major problems with family loans. However, if the business falters and your spouse is left to provide income for the family, you could wind up supporting the company rather than the other way around.

This can work for a while, but if the money-losing venture can't eventually support itself, you need to answer some tough questions, such as:

• Is the problem temporary? For instance, does the business need more time to become stable, or is it suffering from a slump in the economy?
• Is the problem permanent, perhaps due to unrealistic business expectations or long-term market changes, such as the failure of a major customer?
• What changes can you make to improve cash flow and profits?

It can sometimes be difficult for an owner to answer these questions objectively after investing years of sweat equity in a business venture. Your financial advisors can help you realistically assess your situation and determine viable financing alternatives for your family business.