All in the family: the right way to borrow business funds from family members

Black Enterprise, Feb, 1996 by Rhonda Reynolds

You have done your research and uncovered an underserved market. You're ready to launch your business and, of course, need cash. Standing in front of the bathroom mirror you're reciting that smooth presentation to finesse a $30,000 check out of your Uncle Jim or Aunt Jean. Before you finish your monologue, remember that blood may be thicker than money, but don't take it for granted.

"Many entrepreneurs simply don't have the necessary paperwork drawn up or even a promissory note to sign when they receive a family loan," explains Wiley Harrison, a small business accountant in White Plains, N.Y. "Too often, small business owners fail to follow basic but important lending guidelines when they borrow from relatives. And the neglect can result in any number of family and tax disasters."

The obvious reason to hammer out all the details in writing is to keep harmony in the family. If you don't have misunderstandings, holiday dinners won't be an ordeal.

Second, the whole family's taxes can come tumbling down if you can't prove the loan is formal and legal. Many entrepreneurs have been dragged into Internal Revenue Service audits over loan loopholes. For example, when you deposit Aunt Jean's check for $30,000, your bank automatically informs the IRS about the deposit. In fact, all deposits over $10,000 are reported to the IRS. When the deposit does not show up on your personal or business taxes as income, the IRS wants to know why.

An entrepreneur should treat a family loan as carefully and as formally as any other business transaction. According to tax experts and the IRS, a document listing the terms of the loan agreement should be prepared. The terms should include the date of the loan, the amount, the date the loan will be repaid in full, dates of the loan payments, frequency of payments and the interest rate. Above all, have the document witnessed by a notary, not a family member.

With a family loan, the individual providing the money should be sure to charge an interest rate that reflects a fair market value, or the loan may become subject to federal gift taxes. To avoid future strife with the IRS, Steve Pyrek, an IRS spokesperson, explains that entrepreneurs can use section 7872, subsection D of the IRS code for exact federal rules. Every month the IRS publishes acceptable interest rates for short-, mid- and long-term loans from family or friends.

Consider the loan a gift, especially if your family member is not charging you an IRS-acceptable interest rate on the money. Federal tax laws allow individual taxpayers to give up to $10,000 a year tax free to individual family members. A married couple can give each individual up to $20,000 yearly. Amounts above that limit can be subject to gift taxes for the borrower.

Accountants say it's important to keep gift-tax rules in mind when making a family loan, since what starts out as a loan often ends up as a gift.