From the May 1997 issue of Entrepreneur

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.

Family Loans

You can avoid a lot of tax difficulties if you draw up a document listing the terms of the loan agreement, Levey says. The terms should include the date of the loan, the amount, the date the loan will be repaid in full, dates of loan payments, frequency of payments and the interest rate. In addition, the relative providing the money should charge an interest rate that reflects a fair market value. "This way, if it looks like a duck, talks like a duck and walks like a duck, [the IRS thinks] it's a duck," Ochsenschlager says.

What about agreeing to a no-interest loan? If you decide to do that, make sure the loan is not over $100,000. If you borrow more, the IRS will slap on what it considers to be market-rate interest, better known as "imputed interest." That means while your next of kin may not be receiving any interest on the money you borrowed, the IRS will tax them as if they were.

Imputed interest also kicks in if the loan is for more than $10,000 when the business owner has more than $1,000 in annual 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 it sets on a regular basis.

Keep in mind that if you don't 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 won't be able to take a tax deduction if you find you can't repay the loan.

Try A Capital Investment

To play it really safe, both Levey and Ochsenschlager recommend that business owners stay out of the family loan arena altogether. Instead, they suggest making the relative who is providing the money one of the business' shareholders, effectively making the transaction an investment in your company.

This way, it is somewhat easier from a tax standpoint for your relative to write off the transaction as an ordinary loss if for some reason the business fails. (This applies only if the total amount your company received for its stock, including the relative's 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 points out.

In contrast, if your relative simply gives you a loan and your company goes under, the relative's loss would generally be considered a personal bad debt. This creates more of a tax disadvantage for your relative than if he or she were taking a deduction for a loss from an equity investment.

Here's why: Personal bad debts can be claimed as capital losses. This option is available only to offset other 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 isn't repaid may have to wait several years to realize the tax benefits from the loss. In either case, whether the loan is an equity investment or a personal bad debt, your relative won't be able to take a deduction until it becomes totally worthless.

If a loan that cannot be repaid qualifies as a business loan rather than a personal loan, however, the lender receives a deduction against ordinary income and can begin taking deductions even before the loan becomes totally worthless. One catch: The IRS takes a very narrow view of what qualifies as a business loan. Generally, to qualify as a business loan, the loan would have to be connected to the lender's business.

Making your relative a shareholder doesn't mean you'll have to put up with Mom or Pop in the business. Depending on your company's organizational structure, your 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.

Sharing The Wealth

Nonfamily shareholders may also be a good source of funds for expansion or working capital. Here again, when established in the proper fashion, this type of borrowing will likely be treated by the IRS as a loan. This means interest paid by the business is deductible as a business expense, and interest received by the shareholder is treated as interest income on his or her personal tax return. Repayment of the principal is tax-free.

It is important to ensure the loan payments aren't construed as company dividends, and thus taxable to the shareholder. Again, you need to draw up official loan papers and follow the steps outlined earlier concerning the loan terms on interest rates, scheduled payments and maturity date.

Expect the IRS to look closely at this arrangement. Specifically, it will check to see that interest and principal payments are in fact made by you. Another area of scrutiny is your company's ratio of debt to equity. The IRS wants to make sure the loans aren't disguised equity contributions. If there is an excessive amount of debt, the IRS could disregard the loan, as well as any tax deductions claimed.

You're in the danger zone when your company's debt is three times the amount of its equity, Ochsenschlager warns. "From that point on, the IRS is likely to argue that some of that debt really is equity," he says. "You may think the payments are interest, but the IRS is going to call it a dividend, and your company won't get a deduction for it."

While business borrowing from loved ones and shareholders is not a simple matter, it can be a good way to raise capital as long as you follow the necessary safeguards.

Contact Sources

Gelfond Hochstadt Pangburn & Co., 1600 Broadway, #2500, Denver, CO 80202, (303) 831-5000;

Grant Thorton LLP, 1707 L St. N.W., #230, Washington, DC 20036, (202) 861-4115.

Joan Szabo is a writer in McLean, Virginia, who has reported on tax issues for more than 11 years.