Even Shakespeare warned against it. “Neither a borrower nor lender be. For loan oft loses both itselfand friend,” Polonius advises his son in Hamlet. Somehow, though, one suspects the bard neverhad a son or daughter who needed cash to start a small business or go back to graduate school or makea down payment on a first home.
Many people agree that loaning money to those close to you can lead to trouble. At the same time,family members loan each other money all the time, and owners of businesses probably do it more oftenthan most people because they have the money to do so. What are these lenders risking, besidesmoney?
“The danger is that it creates opportunities for family conflict and disappointment, and familybusinesses usually do all they can to avoid any kind of conflict,” says John Ward, professor ofprivate enterprise at Loyola University-Chicago and an advisor to family businesses. Ward says thattoo often loans to family members become “tests of personal responsibility,” rather than simplefinancial transactions. Terms and expectations are left unclear, leaving both sides vulnerable tofeelings of unfairness or betrayal. And, in many cases, loans are never repaid in full, leaving badfeelings on both sides.
On the one hand, parents who loan money to children have been known to try to unfairly to influencethe recipient's personal decisions, such as where to live and what kind of career to go into, whilethe money is still outstanding. On the other hand, borrowers who haven't thought clearly about payingback the loan have been known to get quite defensive when asked about starting a repaymentschedule.
Judy Barber, a family business consultant in Napa, California, talks about the pressures on bothparent and adult borrower from such a loan. “What it can do, unless both people are relating to eachother in an adult way, is reel that young person back into the parent-child relationship,” Barbersays. “Part of that has to do with payment of the loan, and part of it has do with whether the parentsthink the child is spending the money in a way that is beneficial.”
If you are considering loaning money to a child, a brother, or other relatives, you should askyourself a number of important questions first. You have to examine how the borrowers will use themoney, whether the money will really help them, what your expectations of repayment are, and whetherthey are capable of meeting the terms.
THE PAYBACK FROM FAMILY LOANS
Bruce McGrath has seven children and has loaned money to all of them. As president of the McGrathAutomotive Group in Cedar Rapids, Iowa, he also has one son and two sons-in-law working for him. ForMcGrath, deciding to loan money to his kids hasn't been nearly as difficult as deciding not to loanmoney to them.
“Sometimes the worst thing you can do is give them the money,” says McGrath. “The best thing is tosay, ‘Not now—this is something you need to do on your own.'” This is especially true with a familymember who requests money for personal needs, such as a football gambling debt or to keep up thepayments on an expensive car.
Still, McGrath is a willing lender of first resort for his children, and he likes it that way. “Wedon't make any secret of the fact that we've lent money to the kids. And we'll do it again and behappy to do it,” he says. Like many family business owners, McGrath enjoys being able to help hischildren out when they need him, even if it occasionally means he might not see the money again anytime soon. McGrath is willing to loan money to his children if it will strengthen the familyrelationship and help build self-esteem by giving them something worthwhile to strive for. But if themoney is just a bailout, he's less likely to help, fearing that family relationships might onlydeteriorate as a result.
Obviously, when banks decide whether to make a loan, they don't consider the benefits to therecipient's character development and self-esteem. They make a careful calculation, based on theborrower's credit rating, of the risks of default. For personal loans within a family, a good loan isone that is likely to end in full repayment without rancor. Many more personal considerations enterinto the decision.
For the child who is seeking a down payment on a home and has a steady job and a young family, thedownside risk is low. Same for the son or daughter who wants to go to graduate school and has alwaysbeen a good student.
Things get more complicated when the request comes from the daughter who is struggling to get settledand wants money to buy a $25,000 sports car. Or a son who has reached his limit on six differentcredit cards and wants you to help keep the wolves from the door. Or when your brother asks for somemoney to tide him over during his second month of unemployment, even while you know he's hardly donea thing to find a new job.
If a family member who seeks a loan to start a business has shown little affinity for the rigors ofentrepreneurship, and even less horse sense, then it may be a good idea to say no—even if it rufflessome feathers. Better yet, advise the person on how to write a business plan or introduce him or herto someone who can help with startup planning.
Kenneth Kaye, a Chicago psychologist who works with family businesses, counsels realisticexpectations. “Don't go into a business relationship with a family member expecting to change theother person,” says Kaye. In fact, he adds, “Expect that the most difficult thing about that person isonly going to be exacerbated.”
Requests for money to start or expand business ventures are easier to evaluate in objective terms, andprovide a look at the factors that should be in place if any loan is to be a successful transactionfor both sides.
John A. Fusco, president of Gaeta Imports Inc., remembers four years ago when his bank was mergingwith a larger out-of-state bank and started calling in lots of business loans around his Babylon, NewYork, headquarters. Gaeta was asked to pay a six-figure loan in full, even though his business wasprofitable and making its payments faithfully. The problem was that the company didn't have that kindof cash on hand. So Gaeta went to his parents, who were happy to help. “If I didn't have my familyavailable to me, it would have put me out of business,” says Gaeta, who runs the family business withhis sister, Deborah.
The loan started off as interest-only for the first year and was paid off completely at the end of thesecond year, Gaeta says, adding, “The bank lost out in the end.”
Rob Field, a financial planner from Palatine, Illinois, remembers his father loaning him a smallamount of money when he left a CPA firm to start his own financial planning business. It enabled himto buy office furniture and other basic necessities. “He wanted to see his son succeed and believedthat I had the ability to do that and pay him back,” says Field, noting, “I'm sure it would have beenimpossible to get the money from a bank.” Within a few months, Field had paid his father back.
Although both of these loans were handled rather informally, with no set repayment schedule, theyworked because each borrower brought tangible assets and skills to the table. Gaeta had a growingbusiness that he was committed to, and Field brought several years of experience and modest startupcosts.
If you're asked to lend a significant amount to a startup or existing business, try to be a bithard-nosed in evaluating the request. Ken Kaye says he wouldn't advise lending to family membersunless they can get a traditional lender to kick in money as well. “If the person can get outsidecapital and then has family members who want to get in, I don't have a problem with that,” says Kaye.“The problem is when they turn to a relative when no one else will finance them.”
Expect to see a business plan from the borrower and ask good questions about it. And if you make aloan to a family member, avoid any temptation to do it through the family business. It's best to makeit a personal loan with your own funds, says John Ward, although he suspects quite a few familybusinesses have also been used as family banks. “I don't like the idea of lending money from thebusiness,” says Ward. “My major caveat is the symbolism of it and the way it blurs the lines betweenfamily and ownership. It creates a precedent of using company money for personal needs.”
LOAN OR GIFT?
If you end up deciding you do want to provide money to a family member, there are some practicalmatters to consider, including important tax and estate planning issues. These considerations willvary depending on whether you actually make a loan or decide to make a gift instead.
“If there's a 50 percent chance that the person is not going to pay it back, set it up as a gift not aloan, because the lender is setting himself up for disappointment,” says Judy Barber, the familybusiness consultant in Napa. The fact is that many family business loans don't get paid back. Newbusiness ventures fail or relatives whose lives have never quite gotten on track remain derailed, evenafter your money is spent. Knowing this risk, you may still be willing to help a child or other familymember. There's a lot less likelihood for tension if you just give them the money. You might tell themthat if they ever have the opportunity in the future, they can make it up to you. By removing thepretense of anticipating timely repayment, you make the transaction clearer and less burdensome. Ifyou're not willing to give the money to a high-risk family member, you probably shouldn't lend it tohim or her either.
From the standpoint of good estate planning, a gift makes more sense than a loan. A husband and wifecan give up to $40,000 per year tax-free to a child and spouse. If you have considerable assets (morethan $600,000, including life insurance), and know that such estate strategies will be necessary,consider making a gift when a child asks you for money. You can always take the gift intoconsideration when you decided how to divide up your estate among your heirs. But in the meantime, youhelp a family member in need and, perhaps, earn some gratitude.
There are some other tax questions surrounding a loan or gift to a family member as well. Until 1984,you could give a no-interest loan to a child without tax consequences. A U.S. Supreme Court decisionin Dickman v. Commissioner of the Internal Revenue Service held that when no interest wascharged on a loan between family members, the IRS had a right to collect gift tax on the amount ofinterest that should have been charged. The decision threw cold water on the tax dodge of loaninglarge amounts of money to family members in lower tax brackets, who could then turn around and investit.
Now the IRS requires you to use a federally set, variable rate of interest (your accountant canprovide this), or have the difference be considered a gift. If the total gift for a year is stillunder $10,000 no tax will be owed by the family member. But any interest forgiveness must now befactored into your tax picture, since the IRS could anticipate that you are owed interest income andrequire you to pay taxes on it.
“It's great to be a good guy with an interest-free or low-interest loan, but you have to consider theconsequences,” says Mark Kozol, director of tax at Kennedy & Lehan in Quincy, Massachusetts. Don'thesitate to consult with your accountant or tax planner when confronted with these decisions.
Paying for education or health care remains the most favorable way to give money to children orgrandchildren. You can provide any amount of money for education or medical care without taxes. And ifyou loan money for education, without interest, there will be no gift problem so long as therecipients don't have significant investment income flowing to them while in school.
WHEN TO PUT IT IN WRITING
While some experts favor some sort of note or formal agreement even for intra-family loans, othersargue that not all loans need to be put in writing. While Bruce McGrath generally does like to have adocument of some sort, he won't bother with “for the $400 for the car that broke,” when he expects toget repaid within a few weeks. Such short-term, personal loans among family members probably don'trequire much formality, as long as you know the borrower to be trustworthy. If not, and you want themoney back, even a small loan should be written down.
A written agreement can protect both borrowers and lenders. Judy Barber recalls a couple who lentmoney to their daughter to finish graduate school. In their agreement, the daughter was to startpaying back the loan one year after graduation. “Then, four months before graduation, the parentscalled and told the daughter money was tight and they'd like her to start paying now,” Barber recalls.The daughter, who couldn't afford to start the payments, was able to point to the terms of herpromissory note and her parents looked elsewhere for some cash.
Another couple borrowed $8,000 from the wife's mother to use as down payment on a house, with nowritten agreement or repayment schedule. The mother referred to it as her “retirement money.” But whenthe mother's business turned sour four years later, she called in the loan, giving her daughter andson-in-law just a couple of months to come up with it all. No one was happy about it, but a writtenagreement could have avoided such a conclusion.
The most important reason for a written agreement, however, is to protect the lender. It maximizes thechances that the money will be repaid and spells out the terms of the loan so that both sides knowwhat is expected of them.
“If you want the money to be repaid then you must all sign a note and the borrower should probablyalso put up some collateral,” says Mike Cohn, president of The Cohn Financial Group in Phoenix. “Evenif there's no interest stated in the loan, treat it like a legally binding document.”
The agreement should contain a specific repayment schedule, even if payments are not to begin rightaway. And, if circumstances change and you decide the borrower doesn't need to pay you back, Cohnsays, “you can always rip it up later and say you forgive the loan.”
Bruce McGrath reminds us, after all, that money may not always be the most important issue whenproviding a loan for a family member. “The ultimate measure of whether a loan or gift has beensuccessful is the effect it has on our family,” he says. “By that measure, they've all been good.”
Stephen J. Simurda, a business writer in Northampton, MA, is a frequent contributor toFamily Business.