Accepting money from loved ones can be a cheap and flexible option, but it may also lead to conflict and trigger tax implications.

Family and friends are often the first people who help nurture your small business idea. When you’re starting out, their belief in your vision and financial support is invaluable.

While it has benefits, borrowing money from family can cause complications down the road. It’s important to understand the challenges that come with borrowing from family and friends. And if you’re considering taking a loan from loved ones, use our friends and family borrowing worksheet (PDF) to better understand how to borrow in a practical way.

The pros of family and friends funding

  • It’s economical. Depending on the agreement you have, you may not have to pay back the money you borrow from family or friends. If you are paying them back, the interest rate they would charge you is typically much lower than what you’d get from financial institutions. (More on interest rates below.)
  • It may be your only option early in the business. When your business is brand new or very small, you may not have any other funding options apart from your loved ones. Online fundraising sites are another option, but there’s a risk you won’t raise as much money as you need.
  • It can be more flexible. The support of your loved ones through the ups and downs of growing your business can be critical to your business’s success. When they’re financing your business, that support is even more important. If you’re dealing with down times or personal challenges, your friends and family will probably allow you more repayment flexibility than a traditional lender would.

The cons of family and friends funding

  • It may create family conflict. Borrowing money from your loved ones brings with it the potential for misunderstandings and conflict. To help make it a positive experience for everyone involved, have a clear agreement in writing on things like whether the money is a loan or a gift, if you’re expected to repay it, or whether they’ll have a say in business decisions.

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Tip: Have an honest conversation. Would your loved one be OK with losing the money? If there is financial loss, would it affect your personal relationship? These may be tough questions to answer, but they are important to address before borrowing from or lending money to family or friends.

  • It doesn’t build your credit. As a small business owner, your personal credit profile matters if you decide to seek funding at some point or even occasionally lean on your own credit cards to manage cash flow. Borrowing from a business lender also allows you to build your business credit profile, which can help you gain access to more credit as your business grows. A loan from family or friends doesn’t help your credit score since it’s not reported to the credit bureaus.

Tip: Learn about all the different means of financing, from bank loans to invoice factoring, and how they match up with your risk tolerance. Also get a copy of your credit report, so that you can see a detailed breakdown of where you stand.

  • There may be tax implications. A “gift tax” may be triggered if the amount someone gifts you in a year is over a certain threshold, as defined by the IRS. Learn more about the gift tax on the IRS website.

    If the money is a loan, your loved one is required to charge an interest rate in line with IRS guidelines, known as the Applicable Federal Rate (the rate changes every month). Otherwise, the money is considered income that you can be taxed on. If your family member or friend doesn’t charge the AFR, the IRS may also tax them on interest that could have been collected but wasn’t.

How to make an agreement when borrowing from family and friends

Your family member or friend may just want to give you money to show their support. Documenting it can seem like an unnecessary formality, but it’s actually a smart way for both of you to protect your relationship.

You can use a promissory note template online to make a legally binding agreement that you both sign. Here’s how to go about it:

  • Write down the terms you agree on. This includes the amount of the loan and interest rate, when repayment begins, and how long you’ll take to pay the loan back. Also mention what happens if you have difficulty paying or you need to stop payments altogether.
  • Your agreement should specify whether the money is a personal loan or an investment. If it’s an investment, you may be offering them equity in the business, which requires more formal paperwork. You should also agree on whether they’ll be silent investors or will have some say in how you run the business.

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Tip: Have the document reviewed by a third party like a tax attorney or accountant to make sure you’ve covered all your bases. It may seem too formal but, again, this step means you’ve done the best you can to protect your relationship in the future. Ideally, you should also have it notarized.

The bottom line

Family and friends can be an important source of funding for your business, especially as you’re starting out. But the challenges associated with borrowing from loved ones can make it more complicated for you in the long run. As your business matures, talk to your banker to explore other methods of financing, such as loans and business lines of credit.

Sources: Clutch, IRS.