Note-Worthy: The Business Side of Family Loans

Business lawyer speaking to his client regarding asset vs stock purchases.

Here is a wonderful way to sow seeds of dissension among your children:  lend money to one of them.

To understand the calamity that you have unleashed, let’s go back to business basics.

A loan is a transfer of money to someone in exchange for his or her promise to repay it.  The terms should be agreed upon before the money is transferred.  The obvious, and correct, way to handle this type of transaction is through a written promissory note.   Be very wary of the form you use because courts use the very same rules to interpret notes that they use for other types of contracts.

What should be in the promissory note?  Think about the note you signed to buy your house or to purchase your car; a note between family members is no different.  At a bare minimum, the note should contain the amount loaned (the principal), the interest rate, the date of the loan, the person who loaned the money and is expecting to be repaid (the payee), the person receiving the loan and promising to repay (the maker), the terms for repayment (installments, lump sum, interest during the term), the place of payment, and whether the note can be paid off before its due date.  It should be signed by the maker.

If you want it to be “negotiable,” which would be wise, then the note has to contain some specific language.  It should include an unconditional promise to pay or order to pay a specified sum of money, be payable on demand or at a definite time, and be payable to order or to bearer.

There are other terms that need to be ironed out.

What happens if the maker (your child) dies, declares bankruptcy or fails to make a payment?  Is the loan just to your child, or is it also to your child’s spouse?

Will your child pledge collateral that you can seize if your child defaults?  If so, you need a separate written agreement and should “perfect” your interest in the collateral by taking additional steps.

On your side, what happens to the loan, and your child’s obligation to pay, if you die before the loan is paid in full?  Does it become part of your probate estate?  Is it canceled?  Is it deducted from the child’s share of inheritance?

There are some pesky tax issues

The IRS is concerned about every business transaction, and your loan to your child is no exception.  If the interest rate is not high enough, then the IRS may impute an interest rate.  If the loan is written off during your lifetime, then that has a tax consequence.  About that cancellation on death idea – the IRS calls those self-canceling installment notes, or SCINs, and has an opinion about that, too.

Don’t forget family dynamics.

Are you, or your executor, willing to sue your child if there is a default?  How will your other children react?  Do you care?

Mixing business with personal – what could go wrong?

Virginia, a 1982 SMU law school graduate, has advised clients for over 35 years.  For more information, visit hammerle.com, and for newsletter sign-up, email legaltalktexas@hammerle.com.  This column does not constitute legal advice.