Even Shakespeare warned against it. “Neither a borrower nor lender be. For loan oft loses both itself and friend,” Polonius advises his son in Hamlet. Somehow, though, one suspects the bard never had a son or daughter who needed cash to start a small business or go back to graduate school or make a 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 often than most people because they have the money to do so. What are these lenders risking, besides money?
“The danger is that it creates opportunities for family conflict and disappointment, and family businesses usually do all they can to avoid any kind of conflict,” says John Ward, professor of private enterprise at Loyola University-Chicago and an advisor to family businesses. Ward says that too often loans to family members become “tests of personal responsibility,” rather than simple financial transactions. Terms and expectations are left unclear, leaving both sides vulnerable to feelings of unfairness or betrayal. And, in many cases, loans are never repaid in full, leaving bad feelings on both sides.
On the one hand, parents who loan money to children have been known to try to unfairly to influence the recipient’s personal decisions, such as where to live and what kind of career to go into, while the money is still outstanding. On the other hand, borrowers who haven’t thought clearly about paying back the loan have been known to get quite defensive when asked about starting a repayment schedule.
Judy Barber, a family business consultant in Napa, California, talks about the pressures on both parent and adult borrower from such a loan. “What it can do, unless both people are relating to each other in an adult way, is reel that young person back into the parent-child relationship,” Barber says. “Part of that has to do with payment of the loan, and part of it has do with whether the parents think 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 ask yourself a number of important questions first. You have to examine how the borrowers will use the money, whether the money will really help them, what your expectations of repayment are, and whether they 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 McGrath Automotive Group in Cedar Rapids, Iowa, he also has one son and two sons-in-law working for him. For McGrath, deciding to loan money to his kids hasn’t been nearly as difficult as deciding not to loan money to them.
“Sometimes the worst thing you can do is give them the money,” says McGrath. “The best thing is to say, ‘Not now—this is something you need to do on your own.’” This is especially true with a family member who requests money for personal needs, such as a football gambling debt or to keep up the payments on an expensive car.
Still, McGrath is a willing lender of first resort for his children, and he likes it that way. “We don’t make any secret of the fact that we’ve lent money to the kids. And we’ll do it again and be happy to do it,” he says. Like many family business owners, McGrath enjoys being able to help his children out when they need him, even if it occasionally means he might not see the money again any time soon. McGrath is willing to loan money to his children if it will strengthen the family relationship and help build self-esteem by giving them something worthwhile to strive for. But if the money is just a bailout, he’s less likely to help, fearing that family relationships might only deteriorate as a result.
Obviously, when banks decide whether to make a loan, they don’t consider the benefits to the recipient’s character development and self-esteem. They make a careful calculation, based on the borrower’s credit rating, of the risks of default. For personal loans within a family, a good loan is one that is likely to end in full repayment without rancor. Many more personal considerations enter into the decision.
For the child who is seeking a down payment on a home and has a steady job and a young family, the downside risk is low. Same for the son or daughter who wants to go to graduate school and has always been a good student.
Things get more complicated when the request comes from the daughter who is struggling to get settled and wants money to buy a $25,000 sports car. Or a son who has reached his limit on six different credit cards and wants you to help keep the wolves from the door. Or when your brother asks for some money to tide him over during his second month of unemployment, even while you know he’s hardly done a 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 of entrepreneurship, and even less horse sense, then it may be a good idea to say no—even if it ruffles some feathers. Better yet, advise the person on how to write a business plan or introduce him or her to someone who can help with startup planning.
Kenneth Kaye, a Chicago psychologist who works with family businesses, counsels realistic expectations. “Don’t go into a business relationship with a family member expecting to change the other person,” says Kaye. In fact, he adds, “Expect that the most difficult thing about that person is only going to be exacerbated.”
Requests for money to start or expand business ventures are easier to evaluate in objective terms, and provide a look at the factors that should be in place if any loan is to be a successful transaction for both sides.
John A. Fusco, president of Gaeta Imports Inc., remembers four years ago when his bank was merging with a larger out-of-state bank and started calling in lots of business loans around his Babylon, New York, headquarters. Gaeta was asked to pay a six-figure loan in full, even though his business was profitable and making its payments faithfully. The problem was that the company didn’t have that kind of cash on hand. So Gaeta went to his parents, who were happy to help. “If I didn’t have my family available to me, it would have put me out of business,” says Gaeta, who runs the family business with his sister, Deborah.
The loan started off as interest-only for the first year and was paid off completely at the end of the second 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 small amount of money when he left a CPA firm to start his own financial planning business. It enabled him to buy office furniture and other basic necessities. “He wanted to see his son succeed and believed that I had the ability to do that and pay him back,” says Field, noting, “I’m sure it would have been impossible 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, they worked because each borrower brought tangible assets and skills to the table. Gaeta had a growing business that he was committed to, and Field brought several years of experience and modest startup costs.
If you’re asked to lend a significant amount to a startup or existing business, try to be a bit hard-nosed in evaluating the request. Ken Kaye says he wouldn’t advise lending to family members unless they can get a traditional lender to kick in money as well. “If the person can get outside capital 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 a loan to a family member, avoid any temptation to do it through the family business. It’s best to make it a personal loan with your own funds, says John Ward, although he suspects quite a few family businesses have also been used as family banks. “I don’t like the idea of lending money from the business,” says Ward. “My major caveat is the symbolism of it and the way it blurs the lines between family 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 practical matters to consider, including important tax and estate planning issues. These considerations will vary 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 a loan, because the lender is setting himself up for disappointment,” says Judy Barber, the family business consultant in Napa. The fact is that many family business loans don’t get paid back. New business ventures fail or relatives whose lives have never quite gotten on track remain derailed, even after your money is spent. Knowing this risk, you may still be willing to help a child or other family member. There’s a lot less likelihood for tension if you just give them the money. You might tell them that if they ever have the opportunity in the future, they can make it up to you. By removing the pretense of anticipating timely repayment, you make the transaction clearer and less burdensome. If you’re not willing to give the money to a high-risk family member, you probably shouldn’t lend it to him or her either.
From the standpoint of good estate planning, a gift makes more sense than a loan. A husband and wife can give up to $40,000 per year tax-free to a child and spouse. If you have considerable assets (more than $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 into consideration when you decided how to divide up your estate among your heirs. But in the meantime, you help 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 decision in Dickman v. Commissioner of the Internal Revenue Service held that when no interest was charged on a loan between family members, the IRS had a right to collect gift tax on the amount of interest that should have been charged. The decision threw cold water on the tax dodge of loaning large amounts of money to family members in lower tax brackets, who could then turn around and invest it.
Now the IRS requires you to use a federally set, variable rate of interest (your accountant can provide this), or have the difference be considered a gift. If the total gift for a year is still under $10,000 no tax will be owed by the family member. But any interest forgiveness must now be factored into your tax picture, since the IRS could anticipate that you are owed interest income and require 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 the consequences,” says Mark Kozol, director of tax at Kennedy & Lehan in Quincy, Massachusetts. Don’t hesitate 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 or grandchildren. You can provide any amount of money for education or medical care without taxes. And if you loan money for education, without interest, there will be no gift problem so long as the recipients 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, others argue that not all loans need to be put in writing. While Bruce McGrath generally does like to have a document of some sort, he won’t bother with “for the $400 for the car that broke,” when he expects to get repaid within a few weeks. Such short-term, personal loans among family members probably don’t require much formality, as long as you know the borrower to be trustworthy. If not, and you want the money back, even a small loan should be written down.
A written agreement can protect both borrowers and lenders. Judy Barber recalls a couple who lent money to their daughter to finish graduate school. In their agreement, the daughter was to start paying back the loan one year after graduation. “Then, four months before graduation, the parents called 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 her promissory 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 no written agreement or repayment schedule. The mother referred to it as her “retirement money.” But when the mother’s business turned sour four years later, she called in the loan, giving her daughter and son-in-law just a couple of months to come up with it all. No one was happy about it, but a written agreement could have avoided such a conclusion.
The most important reason for a written agreement, however, is to protect the lender. It maximizes the chances that the money will be repaid and spells out the terms of the loan so that both sides know what is expected of them.
“If you want the money to be repaid then you must all sign a note and the borrower should probably also put up some collateral,” says Mike Cohn, president of The Cohn Financial Group in Phoenix. “Even if 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 right away. And, if circumstances change and you decide the borrower doesn’t need to pay you back, Cohn says, “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 when providing a loan for a family member. “The ultimate measure of whether a loan or gift has been successful 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 to Family Business.