The Family Business Loan
What Do You Do When Your Children Ask for Money to Start a Business?
We would like to introduce you to John Duncan.1 John came to us about a year ago. He had built an extraordinarily successful private business that he recently sold to take his "chips off of the table" and be able to spend more time with his wife and grandchildren. John and his wife Diane have two children. Their oldest daughter, Molly, is 34, married with two children. Their other daughter Katie is 28, unmarried with no children but has a serious boyfriend. John explained that Katie recently asked him to help fund a new yoga studio. In the conversation, Katie gently reminded John that he and Diane helped fund Molly’s startup and it was only fair that they help Katie. John understood immediately that Katie would not qualify for a conventional business loan, and in order to come up with the money that Katie needed he and Diane would either have to gift her the money, lend her the money, co-sign on a commercial loan, invest as a stakeholder in her proposed business or engage in some combination of these funding paths.2
Because of the recent sale of John’s business, it is well within John and Diane’s resources to help with some, or all, of these funding strategies without jeopardizing their lifestyle or financial future. Notwithstanding the fact that they could help, John wondered whether they should help. He harbored concerns about freely turning over a large sum of money to Katie for several reasons, not the least of which was the inherent risks that any new business faces. That said, John explained to us that since they had supported Molly’s private business venture, they wanted to make sure that they were treating each child fairly while being as thoughtful as possible. As a successful entrepreneur himself, he admired Katie’s untested ambition and genuinely wanted to find a way to help her without impairing her personal and professional development.
He described Katie as a very bright and balanced person with a gregarious personality and a quick mind. "In just four years she graduated from an Ivy League school at age 23 with good grades and a degree in creative writing" he explained. Despite her success at college, Katie "floated among several jobs that did not work out as she had hoped." He said that Diane had insisted on helping Katie with housing because she "didn’t want Katie to live in an unsafe neighborhood." John said that he fully agreed with Diane, especially in light of Katie’s ongoing efforts to find and build a career. Regarding additional support, John and Diane also pay for Katie’s health and car insurance, and each spouse makes annual exclusion gifts to her — which this year totaled $32 thousand. Katie was "grateful for her parent’s support" but "feels guilty about needing it," especially since her sister became entirely self-sufficient from the moment that she graduated college (other than the business loan).
As Katie has sought to put her life together, she considered going back to school to pursue a career in physical therapy but her heart just wasn’t in it. The one constant in her life for the last 10 years, however, has been a deep and abiding passion for yoga — she is zealous in her personal commitment because of the physical and spiritual benefits she receives and has a deep understanding of the practice of yoga.
John explained that he and Diane funded Molly’s current private business by becoming early investors. Molly holds an MBA from a top-five nationally ranked business school and toiled in the technology world for five years before launching her own startup company in the online media and metrics space. Similar to Katie’s request, Molly approached John about funding. But unlike Katie, Molly came prepared with a well-written business plan, a finely tuned investor pitch, and a specific request that John and Diane become equity stakeholders so that they could also benefit from Molly’s success. As it turns out, all appears to be going well for Molly. Molly’s business has just become profitable, and the board members are considering Series A funding from a group of interested early tech investors.
As we talked more with John, he ticked through his reservations about Katie’s request. He noted that Katie didn’t have a formal business education, lacked business experience, had a poor record of not sticking to difficult tasks and was not particularly skilled with numbers. He also felt she was showing tendencies of becoming more, not less, dependent on family money to support her. When asked whether Katie could overcome some or all of these issues, John was quick to say yes.
We asked him why he "invested" with Molly and he said that he was comfortable with Molly’s business education, work experience in the tech industry, the diverse skill set and experience of Molly’s co-founders and well-researched and well-written business plan. In particular, one of Molly’s partners had successfully started and sold a technology startup and the partner seemed to have an established network within the venture capital and private equity communities. Then we asked him if he would have made the investment in the startup if Molly had not been involved and he immediately said, "No. So many startups fail and investors in single entities lose their entire investment. Until recently, most of our wealth had been concentrated in an illiquid private business. Making angel investments in startups is beyond our risk investment tolerance. Honestly, we became stakeholders because my daughter needed the money and we did not want to simply give her a gift. We wanted her to feel responsible. The same responsibility that any business owner would have to their investors … perhaps more so since some of those investors would be her parents."
Over the course of the morning, we worked with John to further define his concerns about Katie’s request and to help him apply the lessons learned from his investment with Molly. It became clear that there were some critical issues for him to address with Diane so that neither one of them felt the other was enabling Katie in a harmful way. He told us he wanted to be on the same page as Diane regarding the amount of the financial assistance, the type of assistance and the guidelines around obtaining the assistance.
THE INTERNAL AND MARITAL CHALLENGES
A few weeks later, we met with both John and Diane to further address their mutual concerns. We suggested that most parents we work with want their children to become strong and independent people who stand on their own two feet. We also acknowledged that a parent’s support can sometimes impede a child’s development if it is used too often, since that generosity can blunt the natural struggles required to become a differentiated, independent adult. We explained that it is common for parents to "over-function" because they don’t want to see their children experience too much adversity, but warned that when parents use wealth to "soothe and smooth" their children’s struggles it can have the effect of fostering counterproductive behaviors and reinforcing poor decision-making skills, which can eventually lead to adult financial dependence.
Parents’ "over-functioning" can engender a corresponding "under-functioning" in their children. While parental support can create short-term resolutions to immediate anxieties, the patterns of habituated dependence that can result are very difficult to break in later years. John and Diane both acknowledged that their goal was to help support their kids while at the same time doing no harm.
As we discussed how the concepts of over and under-functioning applied to them, it became evident that while both John and Diane were very concerned about Katie’s physical safety, John also had a very real concern about trying to reduce "stress" in Katie’s life. This manifested in his providing things for her that she was perfectly capable of providing for herself. Diane, while initially appearing to be the one who was over-functioning, actually saw the deeper value in having Katie struggle enough to overcome the challenges she faced without being rescued. She had a greater tolerance for the anxiety that Katie’s struggle created in both of them. They had been aware of the pattern, but had not really seen how pernicious it could be for Katie’s long-term development; the stress it put on their relationship, and even in the long term, how it could affect the relationship between Katie and Molly.
We also reviewed the different ways that they might offer Katie support, which included making a large gift to her in excess of the annual exclusion gifts that she has already received, co-investing in her studio (similar to how they co-invested with their daughter’s startup) and lending Katie the money. It emerged that Diane had been in favor of the loan because she did not view it as a "handout" but rather as a pathway to develop Katie’s independence. She liked the loan idea because Katie would not have to undergo the normal underwriting process that commercial banks require. She also liked that the intra-family loan could be made to Katie at much more attractive terms than a commercial bank loan.
In this conversation we talked about some key principles:
- Skin in the game: We discussed how families who find the right balance of parental functioning tend to ask their children to take a significant amount of responsibility for their own support. For example, they may offer to fund a partial down payment or give a low-interest loan, but they expect repayment. If their children want them to help send grandchildren to private school, the grandparents will require their children to pay part of the tuition. In this way, money is used to enhance and not replace the financial independence of their children. On this score, John and Diane were doing pretty well — Katie was largely self-sufficient. They realized that they needed to have some explicit conversations with her and lay out a roadmap of expectations for her to become even more financially independent over time.
- Safe-to-Fail Experiments: We discussed that as families navigate the complexities of independence and dependence, they often engage in some experimentation designed to generate skills building in the rising generation. Some families do this through experiential investment processes in which children are mentored by their financial advisors to gain skills in money and wealth management. The key to these experiments is that failure is a real possibility, that there are real benefits to them if they do well and real consequences if they make poor decisions. It has to be clear that parents will not "rescue" the children from that failure, but that the failure will not be catastrophic. In the conversation, it became clear that, if designed and executed properly, the yoga studio could be an excellent safe-to-fail experiment for Katie.
- Support Networks: We observed that often children entering the adult world don’t have solid support networks that allow them to launch successfully. Those who enter the business world often find peers, mentors and leaders who can help them shape and advance their careers. For those outside structured environments, often the only adult support the children have to spur their growth and development is their parents. This is often not effective for either the parent or the child.
- Structure and Culture: We noted that families who do well in the long term often find structures that support their family cultures. They think carefully about the roles of trusts, loans, gifts, family banks, family policies and the like. The role of structures, and particularly legal structures, is critically important in generating a sense of fairness and equity within the family. Such structures should be carefully drafted and maintained to reflect the family culture and to be supportive of it.
As John and Diane talked this through, they realized that they needed to cut back on their parental overfunctioning by becoming aware of it and holding each other accountable — John particularly asked Diane to help him create what they came to call an "anxiety management system" to check his impulse to do too much for Katie.
As they considered their relationship with Molly in light of the factors discussed above, they realized that she had developed a support network, was clearly invested in terms of her time and energy (she had skin in the game) and that the startup was itself a powerful safe-to-fail experiment. The investment was clearly structured, and the rights and responsibilities of both the company and the investors were well understood and documented. Molly had ticked the boxes they had covered and more.
In looking back on Molly’s success to date, they realized what was missing for Katie. They saw that she needed to connect more with other adults whom she could turn to for advice, inspiration and support. Katie needed a network. They also realized that if they were to fund the business, it would require Katie to have skin in the game and a well-designed structure that would make the process a "safe-to-fail" experiment. They recognized her commitment to yoga, but that her yoga business plan was untested. They knew that if they were to avoid the traps of over-functioning, they would have to come to some written and unwritten agreements with Katie. They agreed that the loan would be made using a written loan agreement and promissory note, which needed to bear the minimum interest rate required to avoid the IRS re-characterizing it as a gift. Additionally, they fully expected to be paid back, but to make the debt less burdensome to Katie’s yoga business, they would structure the note as a non-recourse "interest-only" nine-year note that could be renegotiated if interest rates fell in the future.
COMING TO AGREEMENT
When John and Diane sat down with Katie, they talked to her about their desire to support her dreams, and also expressed their concerns about handing out easy money. They shared the concepts of over-functioning/under-functioning and the need for Katie to take responsibility for her own future both for her sake and for theirs. John and Diane suggested to Katie that they would help fund a large part, not all, of the business. However, they needed to set some conditions around that funding both for their own peace of mind and to ensure that Katie had the best chance of success. They did this by being open and frank with her and allowing her to push back and negotiate rather than merely dictating their terms. Before they finished, all three agreed that Katie would do the following before John and Diane committed any capital:
- Interview several yoga studio owners to learn about the ups and downs of running a yoga studio, how those studios made money, how profitable the various business models were. She would also go to conferences and meet with studio owners and other professionals in the yoga world. Katie noted that the local market was competitive and it was unlikely that she would find people who would help her, so John and Diane agreed to fund her exploratory travels. Katie agreed to document her findings, which everyone thought would be useful.
- Link up with a professional development coach. John offered to connect her to someone he knew, but Diane wisely suggested that this was something she could and should do for herself, thereby avoiding another "over-functioning" moment. Katie was excited about the prospects of taking ownership of the process and finding someone who could help her "find and develop her passion."
- Pursue a degree from the local community college in business. This would give her some grounding in business basics and shore up some of her weak points. Katie resisted but John held his ground. Katie found a program that had an online component that fit her learning style and John and Diane signed off on it. In retrospect, Katie is glad her parents insisted on this.
- Present a thorough business plan. They stipulated that any funding would be premised on a solid business plan and that she needed to gather a group of seasoned business professionals to serve as a board of advisors or sounding board for her business. One of the key people in this group was Sue, the family’s Private Wealth Advisor (PWA). Sue was included both because she was trusted and because John and Diane saw this as a great opportunity to deepen Katie’s individual relationship with a key family advisor. Katie would need the buy-in of at least three of these people (including Sue) on the viability of the business plan before they would fund it. They offered to provide her access to their lawyer and their accountant to provide support as she put together the plan. John also offered, if Katie asked, to connect her with some business contacts. Katie was also not at all excited about this, but John and Diane insisted and Katie ultimately acknowledged that it was a good idea. John and Diane felt good about creating boundaries and not giving in.
- Have skin in the game. Katie said that with going to school and all the work that would be needed to meet the requirements, she would have to cut back on her employment. John and Diane agreed, and they negotiated an agreement for partial support that the family viewed as tuition in the "school of self-discovery." While this sounded fluffy and potentially fed into parental over-function, there were clear expectations around progress to be made, the grades that were expected in school and a recognition that if she failed to meet those expectations, funding for the "school of self-discovery" would be cut off. Because of the skin-in-the-game principle, she was required to work to support a third of her total living expenses.
- Gain professional experience in a startup. Molly offered to invite her to work for a summer with her startup, which Katie did. While not in her field, she grew closer to her sister, had a good time and most importantly learned a lot from people in the company about both business concepts and the stresses and joys of hard work in a scrappy startup.
WHAT HAPPENED NEXT?
Over the next months, Katie followed through on the preconditions to funding. She became increasingly fascinated by business and learned more than she had thought she would. Her market research suggested that the yoga studios she had in mind would not be profitable enough, but that there were as yet unsatisfied opportunities with higher margins in producing well-designed yoga apparel. At one of the conferences she attended she met Kim, who was a talented action-wear designer. Kim had new and interesting design ideas but no clue on how to start and build a business. After months of conversation, they decided that they could be strong business partners. Katie also found a board of advisors who were more than willing to help her. Sue took Katie under her wing and helped her navigate the complexities of putting the board together. Sue and Katie have grown close, as John and Diane had hoped. Katie occasionally reached out to John, who was delighted to help, but she mostly did the work on her own and reported back; all the while her performance coach was helping Katie with discipline, focus, and clarity of communication.
When it came time to present a proposal, Katie and Kim put together a professional business plan complete with samples of the yoga apparel they would make and a three-year projected pro forma. After several iterations, they received the blessing of the three business people her parents had required before making the loan, one of whom was so impressed he took a 10% stake in the company. John and Diane made the loan that the business plan called for and also took a 20% equity stake in the business. They established a limited liability company (LLC) with a formal board of advisors from among the people Katie recruited. Molly serves on that board. Katie and Molly now have small holdings of stock in each other’s companies, which they see as symbolic of their emotional support of their respective work. Katie turns to John for business advice occasionally, but otherwise John is leaning back. He is happy to see Katie making her own way and finding other business people who can support her when she needs it. While Katie will hold a special place in his heart as one of his two cherished daughters, she is now a far more empowered woman, and John is happy to see her coming into her own. Diane is delighted that Katie is gaining financial independence by the day and that a point of tension in her relationship with John is resolved.
The family relationship between John, Diane and Katie has shifted a bit as well. While they were always close, they are finding that they are now in more adult-adult conversations than parent-child ones. Katie will joke with her dad about over-functioning (which is a gentle reminder to him to back off). John and Diane will ask Katie to help them manage their anxiety, which alerts Katie that there is a need for communication and accountability without the issue becoming a source of tension. Diane is happy that she is out of the middle of the dynamic as Katie and John are dealing more directly with each other on both a business basis and a father-daughter basis.
- Identify patterns of over- and underfunctioning.
- Analyze whether there is "skin in the game."
- Consider your "guardrails" on what you will require to make the loan.
- Evaluate the adult support networks that exist for your child.
- Develop processes for managing your anxiety.
- Design safe-to-fail experiments with your child.
- Negotiate a series of mutual agreements as a condition for the loan.
- Ensure that the "structures" you create can be supported by the "culture" of your family. Don’t let structures run too far ahead of the capacities and capabilities of your family.
While not every situation will have the kind of outcome described here, we have found that the principles and approach expressed in this story often help families make significant progress, which decreases the likelihood that funding a business will perpetuate adult dependence.
APPENDIX: ADVANTAGES OF INTRA-FAMILY LOANS
Interest rates for intra-family loans are usually established at or above the published applicable federal rates (AFRs) in effect during the month the loan is made. The AFRs are lower than interest rates charged by commercial lenders, making the loan attractive for the borrower. The parent-lender will generally have to recognize interest income as payments are made. However, there is no income tax if the loan is made to an intentionally defective grantor trust (IDGT) benefiting the child-borrower.3
Child-borrowers often prefer an intra-family loan because there is no formal bank underwriting. This allows children with no or poor credit to obtain financing. In addition, intra-family notes are usually established as "interest-only" debt obligations with repayment of principal at the end of the note’s term. For the child-borrower this means that the principal will be fully leveraged for the full term of the loan. Finally, if the loan proceeds are successfully invested by the child-borrower in a manner that produces a total return greater than the required interest rate on the note, the parent-lenders will have successfully transferred wealth without using any of their available exemption or having to pay gift tax. If the parents have taxable estates, this could translate into more wealth being ultimately transferred to the child-borrower.
The tax risk in any intra-family loan is that the IRS can potentially re-characterize the loan as a gift. Should this happen, a late gift tax return would have to be filed and some or all of the parent’s available exemption amount would have to be used. If the parents do not have enough available exemption to cover the gift, then gift taxes would be due and penalties and interest would also be calculated from the inception of the gift. The parent-lender would be responsible for any resulting gift tax. In 2022, the top federal gift tax rate is 40%.
The IRS generally examines several factors to determine whether an intra-family promissory note is a bona fide loan, and thus not a gift, including:
- Properly executed loan agreement and/or promissory note
- Interest rate terms of the promissory note (for example, established at AFR or higher)
- The economic substance of the transaction
- Whether the loan was made as a recourse or a non-recourse loan
- Whether the borrower posted adequate security
- Written records that indicate both parties treated the promissory note as a loan
- The loan repayment schedule
- The actual history of the note repayments
- How the parties actually treated the loan in their ongoing dealings
As to the last bullet point, the IRS’ position has been that a prearranged plan to forgive some or all of a loan will be construed as a gift at the time of the loan. Notwithstanding prearranged plans to forgive loans, it is quite common for parents to forgive some or all of the interest and principal payments after the loan has been made. For example, many parent-lenders will occasionally forgive the required interest payment up to that tax year’s annual gift exemption amount, which is $16,000 per done in 2022. Thus, married parents have the ability to forgive up to $32,000 of interest per child-borrower, and even more if the loan was made to a trust that had multiple current beneficiaries.4 Unlike a borrower who has to recognize forgiveness of debt income when the borrower’s debt is reduced or eliminated by a commercial lender, when a parent forgives a child’s debt there is no forgiveness of debt income because the Internal Revenue Code specifically excludes gifts from the definition of gross income. Based on the foregoing, parents are generally advised to not forgive all of the required interest payments each year in order to protect against the loan acting as a gift because of the prearranged plan to not collect the required interest or principal.