Most people seek out financial guidance to help protect wealth for their lifetime and to preserve it to the extent possible for future generations. But it seems that the more financial independence that you have, the more you begin to feel and look like a target by your friends and family to help them with their finances in one way or another.
The first answer is to always approach family and friend finance on a fully professional basis. That is, don’t do anything different with friends or family than you would for a complete stranger.
If it is a loan that a family member is seeking, be sure to have that documented. But even before that stage, you should perform a little diligence and underwrite that loan as a banker would. Assess the risk, evaluate the guarantor’s credit quality and seek security or collateral as an alternate means for repayment. If things don’t look too good or the borrower isn’t bankable under traditional underwriting standards, you should consider more stringent terms, and perhaps a higher rate.
Even if you’d like to make a loan that will eventually convert to a permanent gift, you should still have documentation and full underwriting. A common situation for a transaction like this is to assist newlyweds with the purchase of their first home. Treat the loan like a real business loan, with a note, repayment terms and a realistic rate of interest.
Technically, the IRS requires that intra-family loans like this bear a rate of interest. So make sure that the note does indeed have a stated rate that is acceptable to the taxing authorities and either collect that from your child or forgive it in the form of a gift each and every year. Technically, you would still be responsible for reporting that interest income whether you receive it or not.
While that loan is on the record, it will protect that amount of home equity should the borrowers get into financial trouble or the marriage doesn’t work out. In the event of divorce, a future ex-spouse will not walk away with equity caused by your undocumented loan.
For business ventures, whether you are an active partner or a passive investor, I’d apply the same business principles. Evaluate the opportunity based on the merits of the plan and the ability of the people asking for your financial assistance. Don’t be shy about once again protecting your agreement with the proper documentation, guarantees and security.
You also need to make sure that the new or recently funded business has a properly structured operating agreement and other legal documents in place as needed. The operating agreement will speak to who does what and what changes when something hits the fan like sudden death or disability of a key employee or owner. Some of the other agreements may include employment contracts, nondisclosure and noncompetition agreements, outstanding loan agreements and leases with landlords or equipment vendors.
This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific tax issues with a qualified tax advisor and your legal issues with an attorney. US Wealth Management, US Financial Advisors and LPL Financial do not offer tax advice or legal services.