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Financing a family-run enterprise can bring out the worst in some people. So handling the transactions carefully can go a long way toward keeping the peace.

Common sources of financing family firms can include personal savings, credit cards, home equity loans, second mortgages and personal loans -- sometimes from relatives not directly involved in the business.

Here are some financing considerations for family businesses:

1. Plan the financing with your spouse and other relatives involved. This includes the type of financing, repayment schedules and the realistic expected returns from the business.

2. If you borrow from a family member, put the agreement in writing to ensure the repayment schedule is understood, to help secure tax benefits and to promote family harmony.

3. Weigh the charges and risks of various loans: For example, rates are higher when you borrow against a credit card than on a home equity loan, but you don't risk foreclosure on your property.

4. Investigate taking out a loan in the company's name. The rates might be a little higher, there's more paperwork and the qualifications are more rigid, but it helps establish credit for the business, makes it easier to borrow in the future and eliminates strain on the family's finances.

5. If you borrow from traditional lenders or a government agency, such as the Small Business Administration, keep in mind that they insist that business and family finances are kept separate. The IRS also demands this.

Like all lenders, family lenders expect a return on their money. This could come in the form of increased equity in the company. Or it could involve principal and interest payments from the business back to the family member. In either case, keep written documentation. This protects the company at tax time and helps alleviate questions about future payments as the business expands beyond the family. In addition, documentation is important if you seek additional funds from traditional lenders or the government.

Tax Consequences

Family loans must be properly structured for several reasons:

  • The lender must charge an interest rate the IRS considers adequate or there can be negative tax consequences.

  • If the business never pays the lender back, the lender can claim a bad debt deduction. First, a good faith attempt to collect must be made. (Under the tax code, business bad debts are more advantageous than personal bad debts.)

  • If a loan isn't properly documented and the lender is audited, the IRS may say the family loan was a gift and disallow a bad debt deduction. And there could be problems because a gift tax return was filed.

You Might Not Want Funds From Family Members If. . .

  • You qualify for other financing.Higher interest rates may be a small price to pay to maintain independence in the family.

  • It involves a big sacrifice. Be aware of relatives' capabilities and take money only if they won't be hurt by a failure.

  • There's already friction in the family.

These sources can cause the success or failure of the business and put family finances in jeopardy.

Assuming your family business is a success, there shouldn't be any major problems with family loans. However, let's say the business falters and your spouse is providing income for the family. You wind up supporting the business rather than the other way around.

This can work for a while, but if the money-losing venture can't eventually support itself, you need to answer some tough questions:

  • Is the problem temporary? For example, does the business need more time to become stable or is it suffering from a slump in the economy?

  • Is the problem permanent, perhaps the result of unrealistic business expectations or long-term market changes, such as the failure of major customers?

  • What changes can you make to improve cash flow and profits?

In the above scenarios, your accountant can help determine financing alternatives for family-run businesses.