How to structure a business loan from relatives
Loans from relatives have helped more than one business get started or stay afloat. Depending on the outcome, this type of financing can either be a dream come true or the beginning of your worst nightmare.
Here are some tips on how to structure a loan from a relative so you remain close after the deal is done:
- Define what the loan actually is. Is it a truly a loan or more of a gift or early inheritance? You don't want to stay awake at night worrying about paying back a loan that was really intended to be a gift. Conversely, if the money was meant as a gift, you want to make sure you are not unknowingly creating a gift tax liability. Understanding the true intent behind the offer will insure there is no misunderstanding about what is really going on.
- Once you've defined exactly what the loan is meant to be, create a written loan agreement. Combining the two axioms “God is in the details” and “There is beauty in the written word” will help both parties clarify the conditions of the loan. Specify the amount of money received, the length of the loan period, the annual or monthly interest rate, and whether you will make monthly, annual, or balloon payments. Include a demand feature in the loan agreement to minimize Internal Revenue Service triggers for a gift tax. Decide if the relative will have a claim against inventory or other assets if the business fails before the loan is repaid. Hashing out the details might take time, but it also may bring up issues that might not have been talked about in previous loan discussions. It is better to talk about these details before the loan is made than discover you each had different assumptions after the money has been spent.
- Understand the impact of missed payments or outright default of the loan. Make sure you know if the relative is giving you money from savings or coming up with the cash through a home equity loan. Will the relative lose their house if you don't adhere to the loan agreement, or can they easily absorb the loss if you can't repay the loan? Having a lower balance in a savings account is much different than going through foreclosure. You don't want to be the reason a close relative loses their house … and they don't want you to be the cause of that either. While it is generous for a relative to offer a loan, make sure you know the source of the cash.
- Discuss whether the loan should be disclosed to other relatives. Since sibling rivalry has no statute of limitations, your parents might want to openly discuss the loan with other family members before any money changes hands. Following the first three steps can help diffuse concerns that other family members might have about the loan.
Knowing the actual intent of the loan and having a written loan agreement can change the perception about the loan — i.e., that it is less of a casual offer to help out and more of a business transaction. Having everyone understanding the impact of missed payments can help reassure family members that you are not leading the relative into financial ruin.
Loans from relatives can be a lifesaver or the cause of bitter family disputes. Properly structuring the loan can make the road smoother for everyone.
Alison Hinson, owner of Alison Hinson MBA LLC, can be reached at ahinson@midmaine.com.
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