Start Your Own Business, 6th Edition

You may have skirted the bank by getting a loan from family or friends, but you should still treat the situation as strictly business. Putting the agreement in writing not only protects both parties but also your relationship. After all, borrowing money is not the same as borrowing the car.

First, you must state how much money you need, what youll use it for and how youll pay it back. Next, draw up the legal papers—an agreement stating that the person will indeed put money into the business.

Too frequently, business owners fail to take the time to figure out exactly what kind of paperwork should be completed when they borrow from family or friends. Often small-business owners put more thought into figuring out what type of car to buy than how to structure this type of lending arrangement, says Steven I. Levey of accounting firm GHP Financial Group. Unfortunately, once youve made an error in this area, its difficult to correct it.

Your loan agreement needs to specify whether the loan is secured (that is, the lender holds title to part of your property) or unsecured, what the payments will be, when theyre due and what the interest is. If the money is in the form of an investment, you have to establish whether the business is a partnership or corporation, and what role, if any, the investor will play. To be sure you and your family and friends have a clear idea of what financial obligations are being created, you have a mutual responsibility to make sure everyone is informed about the process and decide together how best to proceed.

Most important, says McKeever, Outline the legal responsibilities of both parties and when and how the money should be paid back. If your loan agreement is complex, its a good idea to consult your accountant about the best ways to structure the loan..

Whichever route you take, make sure the agreement is in writing if you expect it to be binding. Any time you take money into a business, the law is very explicit: You must have all agreements written down and documented, says McKeever. If you dont, emotional and legal difficulties could result that end up in court. And if the loan isnt documented, you may find yourself with no legal recourse.

Tax Considerations

Putting the agreement on paper also protects both you and your lender come tax time. Relying on informal and verbal agreements results in tax quagmires. In these cases, you have a burden of proof to show the IRS that [the money] was not a gift, says Tom Ochsenschlager, vice president of taxation for the American Institute of Certified Public Accountants. If the IRS views it as a gift because there was no intention to repay it, then the lender becomes subject to the federal gift tax rules and will have to pay taxes on the money if it is more than $13,000. Also make sure the person providing the money charges an interest rate that reflects a fair market value.

If your friend or family member wants to give you a no-interest loan, make sure the loan is not more than $100,000. If you borrow more, the IRS will slap on what it considers to be market-rate interest, better known as imputed interest, on the lender. That means that while your friend or relative may not be receiving any interest on the money you borrowed, the IRS will tax them as if they were.

No interest is imputed if the aggregate loans are less than $10,000. Between $10,000 and $100,000, the imputed amount is limited to your net investment income, such as interest, dividends and, in some cases, capital gains. To determine the interest rate on these transactions, the IRS uses what it calls the applicable federal rate, which changes monthly. Keep in mind that if you dont put all the details of the loan in writing, it will be very difficult for you to deduct the interest you pay on it. Additionally, the relative who lent the money wont be able to take a tax deduction on the loss if you find you cant repay.

To be absolutely safe, Ochsenschlager recommends that you make the friend or relative who is providing the money one of the business shareholders. This effectively makes the transaction an investment in your company and also makes it easier from a tax standpoint for your friend or relative to write off the transaction as an ordinary loss if the business fails. (This applies only if the total amount your company received for its stock, including the relatives investment, does not exceed $1 million.)

In addition, if your company is wildly successful, your relative will have an equity interest in the business, and his or her original investment will be worth quite a bit more, Ochsenschlager says. In contrast, if a relative gives you a loan and your company goes under, the relatives loss would generally be considered a personal bad debt. This creates more of a tax disadvantage because personal bad debts can be claimed as capital losses only to offset capital gains. If the capital loss exceeds the capital gains, only $3,000 of the loss can be used against ordinary income in any given year. Thus, an individual making a large loan that isnt repaid may have to wait several years to realize the tax benefits from the loss.

If the loan that cant be repaid is a business loan, however, the lender receives a deduction against ordinary income and can take deductions even before the loan becomes totally worthless. (One catch: The IRS takes a very narrow view of what qualifies as a business loan. To qualify as a business loan, the loan would have to be connected to the lenders business.) This will be difficult, so consult an accountant about the best way to structure the loan for maximum tax benefits to both parties.

Making your relative a shareholder doesnt mean youll have to put up with Mom or Pop in the business. Depending on your companys organizational structure, your friend or relative can be a silent partner if your company is set up as a partnership, or a silent shareholder if you are organized as an S corporation or limited liability company.

Even with every detail documented, your responsibilities are far from over. Dont make assumptions or take people for granted just because they are friends or family members. Communication is key.

If your relative or friend is not actively involved in the business, make sure you contact him or her once every month or two to explain how the business is going. When people invest in small businesses, it often becomes sort of their pet project, says McKeever. Its important to take the time to keep them informed.

And, of course, there are the payments. Though friends or relatives who invest in your business understand the risks, you must never take the loan for granted. Dont be cavalier about paying the money back, McKeever says. That kind of attitude could ruin the relationship.

This article is an edited excerpt from Start Your Own Business, Fifth Edition , published by Entrepreneur Press.