Family members are a great source of capital for small business owners.
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But borrowing from a relative also presents certain challenges that can't be ignored. At the end of the day, Uncle Harry's loan to your company is a legal transaction – and it's your job to make sure it's treated that way.
For many small business owners, family loans are a quick and easy source of business capital. But family relationships often cause business owners to treat these loans with much less formality than traditional financing arrangements. That can be problematic for both you and your family lender, especially if the financing arrangement goes south at some point in the future.
From a legal perspective, family loans require just as much formality and documentation as a loan with a bank or other commercial lender. A failure to properly document the lending relationship could even have tax ramifications for you and your family member. If the potential for family financing is on your horizon, here are a few things you need to keep in mind before any cash changes hands.
Clarify the Transaction
It's not unusual for the topic of a family loan to arise in the context of a social situation. But the arrangement you discussed over Thanksgiving dinner and the arrangement your family member thought you discussed could be two different things. From the outset of the lending relationship, it's important to formally clarify the nature of the transaction. The transaction could be a business loan, a personal loan, an equity investment, or even a gift. But whatever it is, the legal consequences of the transaction are dependent upon clearly defining its nature early in the lending relationship.
Document, Document, Document
Like any other financing arrangement, a loan from a family member needs to be thoroughly documented to protect everyone's interests and to preserve family relationships. What will the interest rate be? What is the term? What are the consequences of nonpayment? These are all questions that need to be fleshed out and specified in formal loan documents that have been prepared by an attorney, an accountant, or a lending professional.
It's not unreasonable for a borrower to offer collateral for a business loan. But collateral becomes a very sticky subject in a family financing arrangement. A bank wouldn't think twice about collecting a loan by foreclosing on a mortgage. A family member, on the other hand, probably wouldn't put your family in the street to recoup his investment. So if the loan requires collateral, it should be in the form of something that the lender can reasonably collect with a clear conscience.
Documentation of loan details is especially important at tax time. Unless the loan has been properly documented as a business loan, your family member could lose the deductibility of losses he sustains in the transaction and experience other IRS rulings that maximize his taxable income. If the transaction exceeds $10,000 and is so vague that it could be considered a gift, you could even be taxed on the principal.