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What should I know about high interest loans to family?

Posted: Thu Aug 29, 2019 8:15 pm
by EthanAllen
I have a brother who needs a loan to help with cash flow for his small business. He has the ability to get small business loans or loans against his invoices but hates the idea of paying others so much in interest. (As an example, he got quoted a factor of 1.25 for a loan against certain invoices). He asked me if I’d be interested in loaning him the money at the same rate that banks are willing to lend to him because he’d rather pay me those insane rates than a bank.

(I know the usual advice about mixing business with family, not loaning money to loved ones, treating any loan to family as a gift and being happy if they ever pay you back...yada yada. I am not looking for advice about that.)

Assume I go forward with this. What are the practical (tax?) implications of loaning family money at a very high interest rate? I just list the money I get back from him as additional “interest” and it will functionally be treated as any other interest income I’d get from my investments?

I want to follow all laws and not looking to get cute by falsely treating this as a gift or whatever. How should I treat a 25% loan to brother? Thanks.

Re: What should I know about high interest loans to family?

Posted: Thu Aug 29, 2019 8:29 pm
by Mountain Doc
EthanAllen wrote: Thu Aug 29, 2019 8:15 pm How should I treat a 25% loan...
As a very, very risky investment.

Yes, the interest is taxable. Document the loan terms well if you proceed.

Re: What should I know about high interest loans to family?

Posted: Thu Aug 29, 2019 8:30 pm
by EthanAllen
Mountain Doc wrote: Thu Aug 29, 2019 8:29 pm
EthanAllen wrote: Thu Aug 29, 2019 8:15 pm How should I treat a 25% loan...
As a very, very risky investment.

Yes, the interest is taxable. Document the loan terms well if you proceed.
Agreed.

Re: What should I know about high interest loans to family?

Posted: Thu Aug 29, 2019 8:33 pm
by BuddyJet
With the rate that high, you should check your state’s usury law to ensure you are OK.

That said, In my mind, I think of family loans as a gift and am pleasantly surprised if I get anything back.

Re: What should I know about high interest loans to family?

Posted: Thu Aug 29, 2019 8:36 pm
by 7eight9
Why isn't he selling his invoices to a factorer?

Simplified article --- https://www.nerdwallet.com/blog/small-b ... factoring/

I doubt he would be paying 25% (unless his customers are not creditworthy).

Re: What should I know about high interest loans to family?

Posted: Thu Aug 29, 2019 8:50 pm
by EthanAllen
7eight9 wrote: Thu Aug 29, 2019 8:36 pm Why isn't he selling his invoices to a factorer?

Simplified article --- https://www.nerdwallet.com/blog/small-b ... factoring/

I doubt he would be paying 25% (unless his customers are not creditworthy).
He looked into it...the factor rate quoted to him translates to about 25% per year, hence my hypothetical above.

Re: What should I know about high interest loans to family?

Posted: Thu Aug 29, 2019 8:57 pm
by EthanAllen
BuddyJet wrote: Thu Aug 29, 2019 8:33 pm With the rate that high, you should check your state’s usury law to ensure you are OK.

That said, In my mind, I think of family loans as a gift and am pleasantly surprised if I get anything back.
Thanks. Had not checked that.

Re: What should I know about high interest loans to family?

Posted: Thu Aug 29, 2019 9:01 pm
by PhilosophyAndrew
Will others in your family be resentful that you accepted high interest from your brother rather than no- or low-interest? I could imagine problems like that occurring on some families.

Andy.

Re: What should I know about high interest loans to family?

Posted: Thu Aug 29, 2019 9:09 pm
by rasta
PhilosophyAndrew wrote: Thu Aug 29, 2019 9:01 pm Will others in your family be resentful that you accepted high interest from your brother rather than no- or low-interest? I could imagine problems like that occurring on some families.

Andy.
low or no interest loans to family can cause issues with the IRS, i would worry more about those issues than what family members think.

Re: What should I know about high interest loans to family?

Posted: Thu Aug 29, 2019 9:13 pm
by EthanAllen
PhilosophyAndrew wrote: Thu Aug 29, 2019 9:01 pm Will others in your family be resentful that you accepted high interest from your brother rather than no- or low-interest? I could imagine problems like that occurring on some families.

Andy.
I doubt anyone else knows and hopefully no one needs to find out. To be honest i am a bit uncomfortable charging him these rates and I offered to loan it to him at 0%. But he turned that down ... he wants to prove to himself and to me that this isn’t about him wanting a break on anything and he is not looking for any special family favor.

He has a lifetime of goodwill and trust built in and I would trust him with my life, and I know I’m probably the last person he’d ever want to let down. And I think he knows that too, which is why I think he doesn’t even come to me with this unless the market is just mispricing the risk here for whatever reason. And I think his annoyance with that is why he wants to just have me fund things at the same rate.

Re: What should I know about high interest loans to family?

Posted: Thu Aug 29, 2019 9:20 pm
by bikechuck
EthanAllen wrote: Thu Aug 29, 2019 9:13 pm
PhilosophyAndrew wrote: Thu Aug 29, 2019 9:01 pm Will others in your family be resentful that you accepted high interest from your brother rather than no- or low-interest? I could imagine problems like that occurring on some families.

Andy.
I doubt anyone else knows and hopefully no one needs to find out. To be honest i am a bit uncomfortable charging him these rates and I offered to loan it to him at 0%. But he turned that down ... he wants to prove to himself and to me that this isn’t about him wanting a break on anything and he is not looking for any special family favor.

He has a lifetime of goodwill and trust built in and I would trust him with my life, and I know I’m probably the last person he’d ever want to let down. And I think he knows that too, which is why I think he doesn’t even come to me with this unless the market is just mispricing the risk here for whatever reason. And I think his annoyance with that is why he wants to just have me fund things at the same rate.
Sounds like you have a great relationship with your brother which is a beautiful thing. This is the best possible way to screw that up.

Re: What should I know about high interest loans to family?

Posted: Thu Aug 29, 2019 9:21 pm
by RickBoglehead
rasta wrote: Thu Aug 29, 2019 9:09 pm
PhilosophyAndrew wrote: Thu Aug 29, 2019 9:01 pm Will others in your family be resentful that you accepted high interest from your brother rather than no- or low-interest? I could imagine problems like that occurring on some families.

Andy.
low or no interest loans to family can cause issues with the IRS, i would worry more about those issues than what family members think.
The IRS provides the rates that you can charge family members, called AFRs.

https://apps.irs.gov/app/picklist/list/ ... Rates.html

Re: What should I know about high interest loans to family?

Posted: Thu Aug 29, 2019 9:26 pm
by Grt2bOutdoors
EthanAllen wrote: Thu Aug 29, 2019 8:50 pm
7eight9 wrote: Thu Aug 29, 2019 8:36 pm Why isn't he selling his invoices to a factorer?

Simplified article --- https://www.nerdwallet.com/blog/small-b ... factoring/

I doubt he would be paying 25% (unless his customers are not creditworthy).
He looked into it...the factor rate quoted to him translates to about 25% per year, hence my hypothetical above.
So the factor is charging 2 1/8 per month? The factor is accounting for risk in addition to a healthy profit. Realize that most factors get their financing from banks, the factor charges such a high rate to ensure they remain a client of bank. Should financing for them dry up they could be put out of business.

Re: What should I know about high interest loans to family?

Posted: Thu Aug 29, 2019 9:28 pm
by PhilosophyAndrew
Tax issues can be avoided if the rate conforms with the appropriate AFR. The last time I checked, maybe five years ago, those rates were extremely low, which makes low-interest infra-familial loans eminently practical.

My concern is with the emotional impact of the high-rate loan within the family. For example, even if no-interest loans are impractical, family members may not understand this or may expect them to be made in an informal undocumented form. Those expectations may be Irrational, but we all know that family schisms can develop for no good reason.

Perhaps everyone in OP’s family would be copacetic if the terms of the loan became widely known in the family, but it would be good to reflect on this in case not.

Andy.

rasta wrote: Thu Aug 29, 2019 9:09 pm
PhilosophyAndrew wrote: Thu Aug 29, 2019 9:01 pm Will others in your family be resentful that you accepted high interest from your brother rather than no- or low-interest? I could imagine problems like that occurring on some families.

Andy.
low or no interest loans to family can cause issues with the IRS, i would worry more about those issues than what family members think.

Re: What should I know about high interest loans to family?

Posted: Thu Aug 29, 2019 9:34 pm
by BuddyJet
RickBoglehead wrote: Thu Aug 29, 2019 9:21 pm
The IRS provides the rates that you can charge family members, called AFRs.

https://apps.irs.gov/app/picklist/list/ ... Rates.html
I believe the AFR rates are the minimum you need to charge to avoid gift tax implications.

Re: What should I know about high interest loans to family?

Posted: Thu Aug 29, 2019 9:57 pm
by Gnirk
One of the pieces of advice my parents gave me is "Never do business with friends or relatives." You are liable to lose both your money and the good relationship.

Re: What should I know about high interest loans to family?

Posted: Thu Aug 29, 2019 10:13 pm
by Stinky
For your brother’s sake, I hope that he has a business plan that will build enough working capital to avoid taking out 25% loans.

And I hope he builds that capital soon.

Re: What should I know about high interest loans to family?

Posted: Thu Aug 29, 2019 10:17 pm
by RickBoglehead
BuddyJet wrote: Thu Aug 29, 2019 9:34 pm
RickBoglehead wrote: Thu Aug 29, 2019 9:21 pm
The IRS provides the rates that you can charge family members, called AFRs.

https://apps.irs.gov/app/picklist/list/ ... Rates.html
I believe the AFR rates are the minimum you need to charge to avoid gift tax implications.
and not have issues with the IRS as was asked.

Re: What should I know about high interest loans to family?

Posted: Thu Aug 29, 2019 10:24 pm
by EZ James
I am not a lawyer and only skimmed this article. Basically in CA anything over 10% would be usury if they article is correct. The penalty is severe financially and up to 5 yrs in prison if they nail you for “loan sharking”.

https://nvlawllp.com/wp-content/uploads ... rticle.pdf

Re: What should I know about high interest loans to family?

Posted: Thu Aug 29, 2019 10:25 pm
by yangtui
A good way to smooth out small business cash flow is to put as many expenses as possible on a credit card. You get at least a one month float and a percentage discount on your spending. Having said this (and not to be harsh), if your brother has gotten himself into a position where high interest loans are necessary to keep his business afloat, he might want to reassess whether he will be able to continue as a going concern. If it is just a timing issue then credit cards are a good way to help smooth out cash inflows/outflows. Best of luck!

Re: What should I know about high interest loans to family?

Posted: Thu Aug 29, 2019 10:53 pm
by 9-5 Suited
There seem to be a lot of small business loans in the marketplace ranging from 8-10% interest. Is your brother not creditworthy enough to qualify them or is there another reason he can’t go this route?

It’s a little hard to believe that the success rate is high for businesses with such a high cost of capital, cash flow problems, and no access to basic low cost credit, but it’s your money and you know the situation better than me.

And yep, you definitely will be reporting the interest income.