Nearly 38 million families make just enough money to cover their day-to-day expenses. When something unexpected happens that requires additional cash, they don’t have it and need to borrow it. Many 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?
Why lending money to your workers is a risky proposition
While many small business owners are sympathetic to workers with a financial problem, an employer-loan isn’t the best solution for the problem. Making a loan will lead to a flood of requests from other needy employees putting you in the awkward position of saying yes to some and no to others. It creates 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.
Some company-friendly alternatives
Given the risks involved with loaning employees money, it might be better to consider these alternatives:
Allow an advance on their next payroll check. One-third of U.S. households live paycheck to paycheck. Typically an employee that needs a loan so desperately that they turn 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 limits potential losses due to non-payment to just 1 paycheck amount.
Consider making a gift. If it’s a long-term, valuable employee asking for the loan you could always just give them a gift. A $500 gift doesn’t require any paperwork, has little to no legal risk and will foster loyalty. This also helps ensure that the employee won’t come back again for more money, something that does typically happen with loans.
Follow this advice if you want to go ahead and loan your employees money
If you still plan on lending money to employees despite the risks then make sure you do it the right way:
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. Have a loan document drafted by an attorney. 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 willing to offer the loan without interest make sure you 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. First the IRS may treat the interest you should have charged but didn’t as taxable phantom income. Secondly, in some cases the zero interest loans could be seen as a gift which as estate tax implications. The AFRs for different types of loans are published monthly by the IRS.
Establish an in-house formal program. It is almost a certainty that the employee receiving the loan will talk to other employees about it. Keeping it a secret isn’t realistic. Be prepared for other workers to 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. You also need to ensure 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.
