Business owners often turn to family members or friends for capital, usually because they have no other choice. Although the results may turn out quite well (see "A Different Twist on Family Loans," [Article link]), there's a serious potential downside. To minimize risks, Allen Berger, a partner at Chicago accounting firm Blackman, Kallick, Bartelstein, makes the following suggestions:
(Ask yourself (and answer) tough questions before cash ever passes hands. For the business owner, those questions include (1) Have you exhausted all other possible financing sources? (2) Are you confident that you will be able to pay funds back as expected? and (3) What if you can't?
For the lending family member or friend: Are you willing to walk away from the loan if it can't be paid back? If not, will you be capable of taking tough steps, such as hiring a collections lawyer?
(Document everything (most of the time). "If the lender really doesn't expect -- or need -- to be paid back, then you might as well consider it a gift," Berger says. "But with loans, all terms should be documented just as they would be with any other business venture." That includes the note's duration (or "payment on demand" terms), interest rate, and collateral. If you're uncertain about what interest rate should be charged, check the IRS's monthly table that specifies the lowest rate it will allow. (Anything lower involves what the tax man considers "imputed interest," which means the money is a gift that's liable to be taxed.)