by Stephen J. Simurda
adapted from Family Business magazine
Even Shakespeare warned against it. “Neither a borrower nor lender be. For loan oft loses both itself and friend,” he wrote in Hamlet. Somehow, though, I bet the bard never wanted to start a small business or go back to graduate school only to find himself a little short of cash.
Still, the point he makes has become something of a conventional wisdom these days. Many people feel that it can only lead to trouble to loan money to those close to you. At the same time, family members loan each other money all the time, for reasons ranging from the serious (starting a new business or buying a first home) to the spurious (paying off the $300 you just lost betting on football game). What are these lenders risking, besides just money, when making these loans?
“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 who often works with 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.
Loans to family members can be expressions of trust and caring, but they can also lead to distrust and alienation. Parents who loan money to children have beenknown to try unfairly to influence the recipient’s personal decisions, such as where to live or what career to pursue. On the other hand, borrowers who haven’t thought clearly about the implications of their loan can get defensive when asked about repayment.
Judy Barber, a family business consultant in Napa, California talks about the pressures on both parent and their adult child from a family 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.”
There’s no magical way to determine whether loaning money to family members is a good idea. But there are important questions to ask yourself before doing it. You have to examine how the borrowers will use the money, whether the loan will really help them, what your repayment expectations are, and whether the borrower is capable of meeting the terms.
The Biggest Question
Without a doubt, the biggest question to ask yourself when approached by a family member who wants money is whether you should comply at all. If they want to start a business, but you know they show little affinity for the rigors of entrepreneurship and have even less horse sense, than it may be a good idea to say no, even if it ruffles some feathers (Better yet, advise them on how to write a business plan or introduce them to someone who can help with startup planning). Whatever you do, however, remember that your loan will not turn a sow’s ear into a silk purse.
Kenneth Kaye, 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.”
Loan or Gift?
If you end up deciding you do want to provide money to a family member, there are some personal and 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 make a gift instead. Why a gift? Well sometimes it’s the best way to avoid family fissures.
“If there’s a 50% 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 themselves up for disappointment,” says Judy Barber. The fact is that many family business loans don’t get paid back. 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 at the outset.
Good estate planning can also make a gift the right choice. You can give up to $10,000 tax-free to a child each year. 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.
If you’re lending the money, be careful about interest rates. The IRS says that interest forgiveness must now be factored into the annual $10,000 gift limit. “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, Mass. Don’t hesitate to consult your accountant or tax planner when confronted with these decisions.
Paying for education or health care remain the most favorable ways to give money to a child, or grandchild. You can provide any amount of money for education or medical care without taxes. “It may make more sense to pay for a grandchild’s education than to give money to your kids,” notes Kozol.
What Makes a Good Loan?
If you are lending money to a family member, the expectation is that you want it back. But what makes a loan a good one; a transaction likely to end in full repayment without rancor. For personal loans, the issues are more, well, personal. 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 aughter who is struggling to get settled and wants money to buy a $25,000 sports car. Or when your son has reached his limit on six different credit cards and wants you to help keep the wolves from the door. You, as a member of a family and a business person, must make these judgments for yourself based on how much you want to help and how much good your money will do them, and you.
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.”
When to Put it in Writing
While some experts will argue differently, most agree that not all loans need to be put in writing. The amount and terms of the loan have a lot to do with these decisions. If someone wants $400 to pay for a car-repair bill and expects to repay it by the end of the month, you don’t need to put it in writing.
But for larger amounts that will remain outstanding for some time, a written agreement is a good idea, protecting 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 the protection of 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.