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Employee Loan Agreement

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.

Contents

What is an Employee Loan Agreement?

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.

Pros & Cons of Lending to Employees

Pros

  • 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.

Cons

  • 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.

How to Loan to an Employee

The steps below outline the first-time process an employer should take when loaning to an employee.

Step 1 – Understand the Employee’s Needs

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.

Step 2 – Establish a Lending Procedure

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.

Step 3 – Set the Rate

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.

Step 4 – Create & Sign the Loan Agreement

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.

Step 5 – Keep Records

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”.