Many people have or will lend money to other people in their lifetimes. Often parents lend money to children. Sometimes friends lend money to friends. Businesspeople lend money to other businesspeople. There are many contexts in which one person loans money to another person. Shareholders of the corporation borrow money from their corporations, or the corporations borrow money from the shareholders.
Outside of the typical commercial lending context, loans are often not documented well, and sometimes not documented at all. Even business loans are often not well documented. Regardless of the circumstances, documenting a loan is almost always advised. Even loans from parents to children should usually be documented if the provision of money is intended as a loan and not as a gift.
In the context of parents and children, the law will impose presumptions unless the intent is clearly evident. For instance, money that flows from parents to children is presumed to be a gift unless there is evidence to the contrary. Money that flows from children to parents carries with it a different presumption. Documenting a loan makes the intention clear and avoids misunderstanding and family fighting. A parent can always choose to forgive the loan at a future date; however, if the loan is never documented in the first place, the original intention may never be carried out.
Issues usually arise many years after the money is lent. Issues often arise in the context of the parent’s incapacity or death. At that point, it is much too late to clarify the intention, and family members often find themselves in the position of fighting over the original intention, depending upon who benefits or does not benefit from one position or another.
Outside of the family context, loans should always be documented. This is true whether a loan is made to a friend, neighbor, business person or business entity. Loans should be documented even when the entity may be a single shareholder entity. Loans should be documented for many reasons, including accounting purposes, tax purposes, collection and enforcement purposes and, of course, so that the intention and expectations of the parties are clearly defined, and memorialized and carried out.
Documenting a loan is not complicated, though I suggest for most purposes, especially in a commercial context, that an attorney be engaged to provide the documentation. The key ingredient to documenting a loan is a Promissory Note. A Promissory Note is a legal document that expresses a promise in writing to repay a specified sum is within a specified time period on specified terms. The Promissory Note should include the payment terms, where the payment should be made, what the interest is (if any) and so on. Commercial promissory notes can be three or four pages. Simple promissory notes might be one page. Of course, commercial Promissory Notes will contain many provisions that make the enforcement and collection of the note easier and more certain and put the lender (or the holder of the Note) in a favorable position to collect repayment of the loan.
Whenever a loan is made, some thought should be given to security for the Note. Loans between family members are often made without any security, but I suggest that obtaining security for the loan is still advisable, even among family members – maybe even especially among family members. I see many instances in which family members take advantage of family members.
Loans for commercial purposes or between businesspeople should always have some security. Security is some assurance that the loan will be paid back; and, if the loan is not paid back, will provide some vehicle with which to satisfy payment. Security for a mortgage loan is a mortgage that is recorded on real estate and becomes a lien on that real estate. If the loan goes into default, the mortgagee (the lender) can foreclose on the mortgage and have the property sold to satisfy the debt.
Mortgages are just one type of security. Other types of security might include co-signors, liens in personal property, pledges of stock and other types of security. No person should make a loan without considering the possibility of default – the possibility that the borrower might fail to repay the loan according to the terms of the loan. Loans should not be made without giving some thought to the potential need of having to enforce the terms of the loan if there is a default.
Interest is also always a consideration, even for loans among family members. Many people do not realize that the IRS will impute interest in certain circumstances where interest is not defined. For instance, a loan between family members without any interest defined will be considered a gift of the imputed interest from the lender to the borrower which, in turn, may be deemed income to the borrower. These issues do not often arise, but when they do, they take people by surprise.
Consideration should be given to basic interest as a part of the terms of the loan and default interest that will apply when the loan is in default. Other mechanisms for encouraging repayment of the loan should also be employed as the terms of the loan to encourage payment. In this context, the more terms that are favorable to the lender, the more likely the borrower will repay the loan and the more likely the lender will be able to collect payment of the loan if the loan goes into default.
Finally, loans between entities and their shareholders or other people having ownership interest in the entity should also be in writing. This is true even when there is a single owner, like a single shareholder of a corporation. The law allows people to organize business entities on the premise that the entity becomes a “legal person” that can enter into contracts. A contract with a large corporation is not a contract with the hundreds of thousands of shareholders; it is a contract with the corporation, itself. The same principle applies with a single shareholder corporation.
People often fail to appreciate the difference and separation between a shareholder and a corporation, especially with small, one or two shareholder entities. When a shareholder borrows from a corporation or the corporation borrows from a shareholder, there are two “persons” involved: the corporation and the shareholder. It does not matte that the shareholder effectively makes the decisions for the corporation.
The transactions between a corporation and its shareholders should always be documented. Many, many small corporations document loans only as accounting entries. That practice is efficient, but there is a danger in being too loose. When there is insufficient separation between the corporation and its shareholders, courts have the ability to “pierce the corporate veil” and impose liability on the individual shareholders. Therefore, documenting corporate loans is a way to show respect for the separation between the owner and the entity and to avoid that result. Not documenting a loan, by itself, may not lead to personal shareholder liability, but shareholder liability may be the result when lack of loan documentation is symptomatic of a lack of separation between a corporation and its shareholder(s). Further, if the IRS audits the corporation, they will expect to see separation; if that separation does not exist, there can be negative tax ramifications.
In the end, a loan is an agreement like any other agreement. Agreements should always be documented so that the intention, terms and expectations are clearly stated and clearly understood, both when the loan is made and in the future. When agreements are not reduced to writing, there is room for misunderstanding, disagreements and lack of appreciation for the terms of the agreement. Enforcing agreements that are not in writing is problematic. Memories fade. Past intentions get confused with current circumstances. Therefore, documenting loans is always the best practice.