What happens when an unforeseen life event wreaks havoc on an employee’s finances and they are unable to cover the costs with their current income? They may re-enter the job market in search of higher-paying employment or take on additional debt just to make ends meet.
There is a third option, however – one that can benefit both the employee and the company they work for: employee loans. While loaning money to an employee may seem risky at first glance, employee loans can provide an opportunity to develop a long-term commitment between the employee and your company. They can also help reduce the cost of labor by retaining good employees.
Employee loans are temporary funds awarded to an employee by their employer to help them pay for personal expenses, such as medical bills or school tuition payments, or get them through a financial rough patch. Like personal loans, the employee is expected to repay this loan with interest over time.
However, employee loans usually have a very reasonable interest rate that is used to cover the cost of implementing the loan program, as well as any tax liabilities the employer may be charged with.
Employers can determine the parameters of their loan program, such as the loan amount and the loan term. The employee pays back the money according to the loan repayment schedule, typically via payroll deductions. Thus, employee loans can be viewed as an advance on the employee’s salary.
Employers can offer loans to employees as a type of fringe benefit. However, as with traditional loans, employers should have clear policies and procedures in place for lending money to employees. Business owners should, therefore, take measures to establish a formal employee lending program.
There are many variables to consider when creating an employee loan program, such as the circumstances that determine when an employee can borrow money, the amount the employee can borrow, and the loan repayment term.
We will now look at some of the steps involved in setting up an employee loan program that you can use as a guide to drawing up your own:
Issuing employee loans can affect your taxes as a small business owner. For example, you may incur some extra taxes if you distribute a loan incorrectly. You can avoid this by keeping detailed financial records and by regularly checking the Applicable Federal Rate (AFR). This is a prescribed rate published once a month by the Internal Revenue Service for federal income tax purposes.
If an employee borrows more than $10,000 from your business, you must use the AFR as your minimum interest rate. If you don’t, the IRS may classify your employee’s loan payments as a ‘phantom income’, which is subject to taxation.
It is your responsibility to ensure that workers know what is expected of them when they receive an employee loan. This is why it is a good idea to have a general policy in place that will spell out your employee’s financial options and obligations when it comes to repaying the loan. In other words, a formal policy will specify the terms and requirements of the loan. This will help to eliminate confusion and provide employees with transparent information about the loan program.
Here is an outline of what to include in an employee loan policy:
In addition to having an employee loan policy in place, you may want to ask yourself the following questions when an employee approaches you for a loan:
Generally speaking, an employee who requires financial assistance for an unexpected expense due to circumstances beyond their control is different from an individual who lands themselves in financial trouble because they failed to budget. However, you also need to be mindful of the fact that approving a loan for one employee, but declining another may create a sense of inequity between workers and could result in a discrimination lawsuit.
While it may be tempting to keep an employee loan ‘off the books’, doing so could result in fines or penalties, which doesn’t bode well for business. Thus, you should always keep up-to-date and detailed financial records of your employee loans. This will also prevent your employee’s loan repayments from being subject to taxation.
As mentioned elsewhere, business owners need to abide by state wage reduction laws when it comes to using payroll deductions as a method of repayment for employee loans.
Put simply, some states only allow employers to make use of payroll deductions if it doesn’t reduce their employee’s earnings below the federal minimum wage. If that is the case, most states require employees to authorize that kind of repayment in writing.
Now that we have established some of the key considerations for setting up an employee lending program, the following section will tell you what an employee loan agreement should contain. You can also look online for a template of a loan agreement between an employer and an employee.
However, because there are so many factors to consider when it comes to employee loans, we recommend consulting with a business lawyer when drafting your employee loan agreement to ensure that you have included all the fundamentals. These include:
While it can be beneficial for small business owners to offer employee loans, it’s important to consider both the positive and negative implications before deciding to do so.
If you’ve come to the conclusion that lending money to your employees isn’t right for you, but still want to provide some form of financial aid, there are some alternatives that you can offer instead.
If your business offers 401(k) plans to your employees, investigate whether the plan is ‘qualified’. This will allow employees to borrow up to half of their account balance, or a maximum amount of $50,000, whichever is less. Note that the repayment term for this kind of loan is five years and employees will be charged interest.
If an employee is asking you to borrow money, chances are, they’re desperate. They could be faced with emergency expenses, like unexpected car repairs or medical bills for a family member.
If this is the case, a loan might not actually be the answer. Instead, consider giving them a paycheck advance. This may be the best solution for an employee experiencing a short-term financial crisis because they can’t afford to pay for their expenses until they receive their next paycheck.
Additionally, giving your employees an advance on their salary will cap your business’s potential loss to the amount of one paycheck. You will also save yourself some of the hassles of implementing a formal employee loan.
Many small business owners consider their employees as extended family members, and it can be hard not to sympathize when one of them is facing a financial crisis.
However, before you decide to offer loans to your employees, think carefully about how it could affect your business and whether you can afford to go this route.