Many of our clients find themselves in the situation of lending money to their employees. The following article comes from the Small Business Administration blog (www.sba.gov), and is written by their guest blogger Barbara Weltman. The information is so relevant to our client base that we are reproducing it in its entirety!
From time to time, an employee going through a rough financial patch may turn to an employer for help. As member of your small business family—which is how many owners view their staff—you want to be helpful. But lending money to an employee should only be done after considering all the issues.
There’s no right or wrong answer when someone asks you for a loan. Your decision to help out often depends on the particular facts and circumstances. But before you make a loan to someone on your payroll, here are some of the questions you might want to ask:
- Do you have serious concerns about being repaid? If you aren’t repaid, will the loss materially impact you or your business?
- What happens if you need to terminate the worker before the loan is repaid (e.g., your business contracts; the employee’s performance becomes unacceptable)?
- Will you be setting a dangerous precedent and become an easy mark for other employees? (Don’t think that word about the loan won’t get around, because people talk.)
- Do you want to have the business lend the funds or make it a personal loan?
Alternative ways to help
If you don’t want to become a lender, consider other ways to help a needy employee.
- Advise about loans from your retirement plan. If the employee has an account in your 401(k) and the plan allows loans, the business doesn’t have to become a lender. Instead, the employee can borrow up to 50% of his/her account balance (up to a maximum of $50,000). The plan must charge a reasonable rate of interest and repayment must be made in level payments over a period of no more than five years (there’s an exception to this repayment period for loans to buy homes). But caution the employee that if he or she leaves the job—voluntarily or otherwise—the loan must be repaid in full (usually within 30 or 60 days). The failure to do this results in having the outstanding balance treated as a taxable distribution; if the employee is under age 59-1/2, the distribution is taxable and subject to a 10% penalty. Find details about plan loans from the IRS.
- Advance one paycheck. If there is a short-term need that can be met by simply accelerating the payment of wages that will become due soon, consider suggesting an advance. Make sure you, and your employee, understand what an advance means; it’s just a timing issue for payment. You might also warn an employee about taking a “payday” loan from a commercial lender because these short-term loans entail very high borrowing costs.
Make it formal
If you decide to lend funds to an employee, be sure that the employee signs a promissory note to repay the loan. The note should spell out repayment terms (frequency of payments; interest rate; what happens in case of a default). There are numerous templates online that you can use to create a binding promissory note, but you might want to run it by your attorney to make sure you protect yourself.
Be sure to carry the loan from your business as such on your books. This ensures that loan repayments from the employee won’t be reported as income.
If you want to be magnanimous when setting interest, keep the below-market loan rules in mind for tax purposes. If your business lends money to an employee and fails to charge interest at the applicable federal rate, or AFR (an interest rate set monthly by the IRS and which varies according to the length of the repayment period), you are treated as having received phantom income (the uncharged interest, which is the difference between the AFR and interest, if any, that has been charged). This must be reported as income for your business. However, there is an exception: there’s no imputed interest if the loan is below $10,000 and tax avoidance is not the main purpose of the loan arrangement. And, if you personally lend the money, different rules apply to so-called gift-loans. Note: Currently, AFRs are low because the low-interest environment, but if the Federal Reserve acts to raise interest rates in the future, expect to see AFRs rise as well. Find AFRs here.
It’s great to be helpful to your staff, but this is a business and needs to be run as such. If you have any concerns, to quote Nancy Reagan, just say no. And as always, check with your lawyer or accountant for guidance.