Family Business: Borrowing From Friends & Family

My parents are by far not wealthy. My father retired 15 years ago and has been living off his pension since then. My mother has always been a stay at home mom. Both of them are living comfortably, but do not have a lot of savings.

My family has been truly amazing in coming to the rescue for me, and I am eternally grateful. My father offered to loan me $100,000. Adding this loan to my personal savings, I have been able to amass enough capital to cover my working capital and soft startup costs. Thankfully, this loan won’t cause a huge squeeze on my parents’ quality of life.

Even amongst family and friends, business should still be business. If you end up borrowing from people close to you, it is probably wise to create a structured documented loan. So many relationships have gone sour because of business disputes that arose from the lack of proper paperwork. By making the loan official, there would be no gray area for either party.

You also get to protect family members from any potential tax inquiries and penalties. Without a promissory note, it would be difficult to prove to Uncle Sam that the loan wasn’t actually a gift. If deemed a gift, the lending family member would be subject to a gift tax. Although, if the loan amount is under the annual allowable gift amount of $14,000, it won’t matter.

The same reason goes for charging interest on the loan. The IRS will more likely believe that the loan is really a loan if interest is charged. Also, if you don’t set an interest rate, the IRS will set one for you, and tax the lender for this imputed or phantom interest. So, even though the lender didn’t actually receive any interest payments, he or she will still be taxed as if he or she did. This foregone imaginary interest income may also subject the lender to a gift tax as well.

Caveat: Imputed interest does not apply to interest-free loans smaller than $10,000. Also, if the interest-free loan is under $100,000, these rules apply only if the annual net investment income earned from your loan, in the form of interest, short-term capital gains, royalties, exceeds $1,000. Most likely, your investment income will be $0, so I don’t think most of you will need to worry about this part.

Even though the lender might not have to pay taxes for imputed interest, he or she may still be responsible for a gift tax on the interest-free loan. With a standard interest-free loan, the interest for the entire life of the loan will be counted toward the gift tax on the year the loan was made. With a demand loan, where the lender can request full payment at any time, only the imputed interest accrued on that particular year will be applied toward the gift tax. Hence, you should structure it as a demand loan.

The minimum allowed interest rate, per the IRS, will be based on the Applicable Federal Interest Rate.

In terms of creating a loan agreement, you don’t need to use a lawyer. You can easily download a template online for free. (ie. eForms) As long as both parties sign the document, it’s legal. If you plan to incorporate, it’s cleaner to make the loan directly out to your practice. Otherwise, you would have to re-loan your personal loan to your practice. Your practice would pay the loan back to you, and then you would pay that amount back to your original lending family member or friend. It’s just messier this way. If the loan is made toward your name, you would deduct the interest on your personal income tax return (1040), and if the loan is made toward the practice, interest would be deducted on your corporate return. If you remain a sole proprietor, you should just make the loan out to yourself.



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