Nearly 38 million families make just enough money to cover their day-to-day expenses. As a result, when something unexpected happens that requires additional cash, they often don’t have it and need to borrow it. Some of them turn to their employers for help, especially if the money is needed immediately. What should you do? Do you make the loan or turn them down?
While many small-business owners are sympathetic to workers with a financial problem, an employer-loan isn’t usually the best solution for the problem. Making a loan can lead to a flood of requests from other employees, putting you in the awkward position of saying "yes" to some and "no" to others. It could create an uncomfortable situation if the employee fails to pay on time, asks to renegotiate terms or needs more money. If the employee leaves the company, your ability to collect on the loan diminishes significantly.
Company-Friendly Alternatives to a Loan
Given the risks involved with loaning employees money, it might be better to consider an alternative.
Allow an advance on their next payroll check. Typically an employee who needs a loan so desperately that he or she turns to their boss needs to solve a short-term financial problem. An unexpected medical expense or tuition bill might be resolved by just simply advancing them money on their next paycheck. This is simpler than making a loan and can limit potential losses due to non-payment to just one paycheck amount.
If You Decide to Lend Money...
If you still plan on lending money to employees despite the risks, there are some steps you may want to consider.
Avoid "Off The Book" loans. The majority of loans made by small-business owners to employees are done as off the book (OTB) loans. The owner sees it as a favor to the employee and neither party realizes that there are tax and legal implications when making a loan. Having a loan document drafted by an attorney may be a good idea. If you plan to do this more than once, this document can serve as a standard contract for your loans. Also make sure that the employee acknowledges in writing that they understand the terms and conditions of the loan—especially what happens if they don’t make timely payments.
Charge interest. If you are feeling generous and are considering giving a loan without interest—stop yourself. The IRS doesn’t take kindly to interest-free loans. Failing to charge the minimum interest rate that the IRS considers appropriate—known as the “Applicable Federal Rate” or AFR—could trigger additional taxes. The IRS may treat the interest you should have charged but didn’t as taxable phantom income. In some cases the zero-interest loans could be seen as a gift, which has estate tax implications. The AFRs for different types of loans are published monthly by the IRS.
Establish a formal in-house program. An employee receiving a loan may discus it with other employees. Keeping the loan a secret is probably not realistic, and other workers may come knocking on your door. When working on the first loan, establish a set of guidelines that apply to all employee loans, including maximum amounts, payment terms, interest rate charged and types of loans that you will consider making. Check that the program complies with laws relating to lending and collections. Failing to do this could open up your business to claims of discrimination by employees who are rejected for loans.
Deciding whether or not to loan the money to an employee can be a difficult decision based on the situation. Think carefully before saying "yes." And if you do agree to give a loan, be smart and outline the rules and expectations surrounding the loan.
The information contained in this article is for generalized informational and educational purposes only and is not designed to substitute for, or replace, a professional opinion about any particular business or situation or judgment about the risks or appropriateness of any financial or business strategy or approach for any specific business or situation. THIS ARTICLE IS NOT A SUBSTITUTE FOR PROFESSIONAL ADVICE. The views and opinions expressed in authored articles on OPEN Forum represent the opinion of their author and do not necessarily represent the views, opinions and/or judgments of American Express Company or any of its affiliates, subsidiaries or divisions (including, without limitation, American Express OPEN). American Express makes no representation as to, and is not responsible for, the accuracy, timeliness, completeness or reliability of any opinion, advice or statement made in this article.
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This article was originally published on November 26, 2014.