You've reached a crucial crossroad in your business. It's time to expand, but you lack the necessary capital to make it happen. You'd rather not apply for a bank loan, so what do you do? Keep your business in neutral until some new-found cash shifts your company into drive?
Perhaps you're considering tapping a flush shareholder or close relative. If you decide to take this route, do so cautiously. There are some important lending signposts to follow so you won't come up against an IRS roadblock.
Too frequently, small-business owners fail to take the time to figure out exactly what kind of paperwork should be completed when they borrow from family or stockholders. "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, a director with the Denver accounting firm Gelfond Hochstadt Pangburn & Co. Unfortunately, once you've made an error in this area, it's difficult to correct it, he explains.
To avoid problems with these types of lending arrangements, be sure to treat a family or shareholder loan as formally as any other business transaction. Unless a formal loan agreement is drawn up, experts say, it's too easy, especially with relatives, to simply think "No need to worry about repayment; it's all in the family."
Relying on informal and verbal agreements is when tax quagmires arise. "In these cases, you have a burden of proof to show the IRS that [the money] was not a gift," says Tom Ochsenschlager, a partner in the Washington, DC, office of accounting firm Grant Thornton LLP. If the IRS views it as a gift, then the lender becomes subject to the federal gift tax rules and is required to pay taxes on the money if it is over $10,000.