Thinking of loaning money to a family member or friend, but worried about the legal implications? If you have second thoughts about loaning money to a friend or family member, you are right to be concerned. Informal loans can have negative ramifications down the road. This article addresses two of those implications, and offers some simple solutions to best protect you – the lender.
Many loans to family members and friends are informal in nature made over dinner or simply based on a handshake. While some lenders manage to come away unscathed by this type of informal agreement, certain issues should be contemplated prior to entering into an agreement to loan money. For instance, how will the borrower pay you back? Will he or she make installment payments? If so, how often? Are you going to charge interest on the loan? If so, at what rate? What if the borrower defaults on a loan payment? How will you collect?
If considering these questions is giving you anxiety about your potential loan, stop and consider whether you would be better off not loaning the money to that friend or relative in the first place. If you still intend to go through with your loan agreement, there are a couple of legal implications you should take into account.
One such implication is that an oral contract or agreement based on a handshake may not be enforceable. The Statute of Frauds dictates whether an agreement must be in writing and signed to be enforceable. See Va. Code Ann. § 11-2. One example of an agreement that must be in writing and signed is an agreement that cannot be performed within one year. See Va. Code Ann. § 11-2(8).
Let’s say you loan your cousin Scott $10,000, and Scott is going to pay $200 per month until he pays you back. Based on those terms, it will take Scott approximately four years to pay you back. This is an example of an agreement that cannot be completed within one year, and must be in writing and signed by Scott in order to be enforceable.
Agreements that cannot be performed within one year are not the only ones to look out for. For example, instead of $10,000 say you loaned Scott $25,000, but this time Scott is going to pay you back in two monthly installments of $12,500. Now, your agreement can be completed within a year, but it still needs to be in writing and signed by Scott to be enforceable. This is because pursuant to the Statute of Frauds any agreement to lend money or extend credit in the amount of $25,000 or more must also be in writing and signed to be enforceable. See Va. Code Ann. § 11-2(9).
The Statute of Frauds was intended to protect against fraud, and should not be used to benefit a borrower whose goal is to perpetuate fraud. Therefore, if you have already made an oral agreement which does not comport with the Statute of Frauds, there still may be ways to enforce the agreement. However, to ensure that your loan agreement is enforceable it’s best to put it in writing and make sure it’s signed by both the lender and the borrower.
Yet another implication to consider when making a loan to a family member or friend is the gift tax. Gift tax applies to “any transfer to an individual, either directly or indirectly, where full consideration (measured in money or money’s worth) is not received in return.” See the IRS Website, at https://www.irs.gov/businesses/small-businesses-self-employed/frequently-asked-questions-on-gift-taxes. The IRS may construe a loan to a family member or friend as a gift if the lender does not clearly require repayment from the borrower.
For instance, revisit our $25,000 loan to Scott, but this time let’s say you told Scott he can pay you back “whenever he has the money.” Aside from the Statute of Frauds issues this raises, your agreement with Scott may also put you on the hook for gift tax. To the IRS, this may look less like a loan to Scott and more like a gift, requiring you to pay the gift tax.
Keep in mind that there is an annual gift tax exclusion of $15,000 per person per year. See the IRS Website, at https://www.irs.gov/businesses/small-businesses-self-employed/frequently-asked-questions-on-gift-taxes. So, if you only loaned Scott $10,000, to pay back “whenever he can,” – you would not owe gift tax because that number is less than the $15,000 exclusion (so long as you did not gift Scott any more than the $15,000 total that year). You may however be required to disclose that “gift” on your taxes.
The best way to avoid the presumption of a gift is to create a formal, written loan agreement, which sets out specific terms for repayment. Rather than stating that Scott can pay you back whenever he has enough money to do so, you should require Scott to pay you back in installment payments.
Another way to avoid gift implications is by requiring Scott to pay you interest on the loan at the federal interest rate. Not only would that create an incentive for Scott to pay you back quickly, but it is persuasive evidence of a loan rather than a gift. In other words, the more formal the better – creating formal, written, specific terms may help you avoid the IRS misconstruing your loan as a gift.
With the holidays coming up, loaning money to family members and friends may be a topic of discussion at the dinner table. Before you shake on it, think about the implications. Observing formalities like preparing a written contract, having both parties sign the contract, stating specific terms for default and payment, and requiring interest at the commonly accepted rate, may be beneficial in the long run.
If you need help drafting a written agreement regarding a loan, the attorneys at Surovell Isaacs & Levy PLC can help guide you. Call us today at 703-570-6368, and ask for Kaley Duncan, or reach out on our website to schedule a consultation.
Posted in: Contracts