An employee loan agreement is a contract that acts as a framework for when a company lends an employee money. It establishes important terms such as the loaned amount, the interest rate, the length of the contract, and the rules regarding repayment. By drafting a loan agreement template, a company can establish a standard lending process for their employees, ensuring terms remain fair and consistent from one loan to the next.
An employee loan agreement is a form used to document that a business lent money to one of their employees. The money can be provided to aid an employee with a major life expense (from school tuition to homeownership), to near-term expenses they can’t afford due to a financial crisis (such as rent, food, car payments, and more). Regardless of the reason the employee was provided money, they will be expected to pay back the loan over a specific amount of time, with interest.
- Improves employer-employee relations – Helping an employee in need aids in breaking down the corporate “wall” from employer to employee, and aids in forming a strong bond with the employee.
- Increases employee productivity – Financial worries can weigh an employee down heavily, and reduce their concentration on their tasks at hand.
- Promote company image – While this should be an afterthought for the business that decides to loan to their employees, it is a welcome benefit.
- Could face more loan requests – If employees learn that another employee received a loan, they could make the same request to the employer. A company should not offer a loan to an employee unless they’re willing to offer a loan to all employees.
- Risk of losing the loaned money – There’s always a chance that the employee defaults on the loan. This risk is decreased if the employer deducts loan payments from the employee’s paycheck – but the risk of them quitting (and leaving the loan unpaid) remains the same.
- Can complicate taxes – if the employer doesn’t issue the loan correctly or they fail to match the AFR for loans over $10,000, they can complicate their taxes significantly.
- Discrimination issues – if an employer grants a loan to one employee, but denies a loan to another employee (even if the reason is valid), the company can open itself up to a potential discrimination lawsuit.
The steps below outline the first-time process an employer should take when loaning to an employee.
Before deciding to loan to an employee or not, understand exactly why they need the money. If the employee has deep-seated money management issues, a loan will most likely serve as a temporary “band-aid” for their issues, and could even worsen their financial situation. However, if the employee was faced with a medical crisis and is in medical debt (for example), a loan could make a major difference in their life. At the end of the day, the decision is up to the employer.
To simplify any future loans the company may issue, they should establish a standardized policy that clearly informs employees the types of loan terms they qualify for, what the disqualifying criteria is (if any), and the maximum amount ($) that can be lent. Also included in the policy should be the name(s) of those that can grant authorization for a loan and the exact process employees need to follow in order to acquire a loan.
For loans above $10,000, the employer will need to charge the employee an interest rate at or above the current AFR (Applicable Federal Rate). A list of the current rates can be found at the IRS’ Index of Applicable Federal Rates Rulings.
What if I charge an Interest Rate below the AFR?
Loans with interest below the current AFR are known as “below-market” loans. The difference between the amount of interest an employer charges and the current AFR is known as imputed interest.
For example, let’s say an employer lent their employee a $30,000 below-market loan. They charged their employee a yearly rate of .5%, and the then-current AFR was 1% for short-term loans. One (1) year later, the employee paid off the loan in-full and paid total interest of [30,000 x .005 = $150]. Per the IRS, the employer should have collected 1% interest, which would have totaled (30,000 x .01 = $300).
The difference that was paid [$300 – $150 = $150] is imputed interest. The IRS would thus classify the $150 difference as income, requiring the employer to pay taxes on it. Imputed interest exists to prevent employers from committing tax avoidance.
The loan agreement will need to establish the major terms of the loan, including:
- The names of the employer and employee;
- The date the parties are entering into the agreement;
- The amount of the loan ($);
- The interest rate;
- The amount ($) the employer will deduct from the employee’s paycheck to pay for the loan;
- The date of the first payment;
- What happens should the employee default on the loan; and
- The signatures of the employer and employee.
The employer should keep a version of the loan agreement as a template. By pre-filling out fields that will often remain unchanged (such as the company name and address), the company can use the document repeatedly for any future loan agreements they enter.
Regardless of the amount loaned, employers should keep diligent records of every loan made to an employee. A copy of the loan agreement should be kept in a secure place, and the loan itself should be accounted for in the company’s books. If the loan will be paid within a year, the company should list the loan as a “current asset” in its balance sheet. If over a year, it should be considered a “long-term asset”.