The following excerpt is from Entrepreneur’s book Finance Your Business. Buy it now from Amazon | Barnes & Noble | iTunes
When borrowing from family and friends is the only way to start or fund a business, the following steps can greatly reduce that risk.
First, you must inform the person you’re borrowing from how much money you need, what you’ll use it for and how you’ll pay it back. Next, draw up the legal papers — an agreement stating that the person will indeed put money into the business.
Too frequently, business owners fail to take the time to figure out exactly what kind of paperwork they should complete when they borrow from family or friends. “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, now-retired senior principal and CEO of accounting firm GHP Horwath. Unfortunately, once you’ve made an error in this area, it’s difficult to correct it.
Your loan agreement needs to specify whether the loan is secured (that is, the lender holds title to part of your property) or unsecured, what the payments will be, when they’re due and what the interest is. If the money is in the form of an investment, you have to establish whether the business is a partnership or corporation and what role, if any, the investor will play. To be sure you and your family and friends have a clear idea of what financial obligations are being created, you have a mutual responsibility to make sure everyone is informed about the process and decide together how best to proceed.
Most important, says Mike McKeever, author of How to Write a Business Plan: “Outline the legal responsibilities of both parties and when and how the money should be paid back.” If your loan agreement is complex, it’s a good idea to consult your accountant about the best ways to structure the loan.
Whichever route you take, make sure the agreement is in writing if you expect it to be binding. “Any time you take money into a business, the law is very explicit: You must have all agreements written down and documented,” says McKeever. If you don’t, the resulting emotional and legal difficulties could end up in court. And if the loan isn’t documented, you may find yourself with no legal recourse.
Putting the agreement on paper also protects both you and your lender come tax time. Relying on informal and verbal agreements results in tax quagmires. “In these cases, you have a burden of proof to show the IRS that [the money] was not a gift,” says Tom Ochsenschlager, vice president of taxation for the American Institute of Certified Public Accountants. If the IRS views it…