Employee Loans: A Guide To Loaning Money to Employees

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.

What is an Employee Loan?

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.

Key Factors To Consider for Employee Loans

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:

1. Determine the Interest Rate of Your Employee Loan

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.

2. Draw Up a written employee loan policy

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:

• What makes an employee eligible for a loan: Will loans to employees only be granted for instances of financial hardship, or will any reason suffice? Will the employee need to provide evidence of their financial situation in the form of documents? Can any employee apply for a loan, or only those who have worked at the company for a certain period?
• Loan amount: Determine a budget for your employee loan program, as well as the exact amount you will lend to employees. This can be a fixed amount or a percentage based on the employee’s salary.
• Loan term: Employee loans are short-term loans that are typically repaid within two to three years. This is because it becomes challenging to maintain a fund for loans if they are being repaid over a long time. Having a repayment schedule in place is also meant to ensure timely payments and to prevent the employee from defaulting on the loan.
• Repayment terms: The most common method of recovering loan payments from your employees is to deduct the amount owed from the employee’s paycheck. However, you will need to check that this repayment method complies with your state’s wage reduction laws before you can implement it.

Other Considerations Before Lending Money to EMployees

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:

• What is my employee’s credit report? Do they manage their money responsibly?
• What will the money be used for?
• Do I have any doubts about being repaid?

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.

3. Keep Pristine records of Your Employee Loans

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.

State Laws for Employee Loans

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.

Contents of an Employee Loan Agreement

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:

• The parties involved: This includes the business’s name, the employee who is being issued the loan, and the name of a witness.
• Relevant dates: The date all parties signed the agreement and the date when the loan becomes effective.
• Promissory note: A promissory note is a legal document that summarizes the loan’s repayment terms, such as the payment amount, the payment frequency, the interest rate, and what happens if the employee defaults on the loan.
• Signatures: This includes capturing the signature of the employee borrower and those of the witnesses present during the signing.

The Pros and Cons of Employee Loans

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.

Pros of Employee Loans

•  Alleviates financial stress. Employees who are struggling with debt or living paycheck-to-paycheck may experience high levels of stress as a result of their financial woes. Employee loans can assist in alleviating some of that stress, so your staff can focus on their work.
• Increases production. Financial stress in an employee’s personal life can lower their productivity at work. Offering a reprieve may assist them in getting back on track, leading to increased productivity levels.
• Improves morale. Being actively involved in supporting your employees’ financial needs can boost morale because it demonstrates that the company values and cares for its employees.
• Contributes to employee retention. Employee loans can be an effective way of reducing turnover because they may increase company loyalty.

Cons of Employee Loans

• Risk of the employee borrower defaulting. There is always the possibility that the employee borrowing money might not pay the loan back at all. If an employee decides to leave the company before the loan term is up, you may also have a hard time recovering the rest of the funds owed to you. It is, therefore, a good idea to evaluate how this kind of setback will impact your business before you decide to implement any employee loan programs.
• Risk of friction in the workplace. If you offer one employee a loan, you might need to prepare for loan requests from other employees as well. This could put financial strain on your business and result in workplace friction. There is also the possibility that owing money to an employer could create an uncomfortable working environment for an employee. This could have a negative impact on your relationship with your employees.
• Pressure to continue lending money. Employees who have received a loan from you in the past may request to borrow more money from you in the future. They may also try to negotiate a longer loan repayment term or reduce their interest rate if they’re still struggling financially.

Employee Loan Alternatives

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.

Retirement Plan Loans

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.

Paycheck Advance

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.

In Conclusion

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.

Keller offers a diverse range of consultation services to support businesses in various aspects. Contact us today for personalized assistance and solutions.