Employee Loans: What To Know Before Loaning Money to Employees
Financial stress is no joke. Struggling with debt or living paycheck-to-paycheck can negatively affect someone’s personal life and affect their work. Money problems can increase employee absenteeism, tardiness and disengagement. A 2016 study found that almost 60% of respondents who were struggling with their finances were unable to focus on work. According to the study, the top three factors affected by financial issues were stress (76.1%), inability to focus on work (59.4%), absenteeism/tardiness (34.2%).
That’s where employers can help. Although it might not sound risky, employers might want to consider giving an employee a loan with money from the business. Jennifer Heim, program founder and director of the Chicago-based Detour 2 Discovery Day School, has given loans to her employees for years.
“I had an employee come to me a decade ago because she was struggling with debt,” Heim said. The employee had gone to a payday lender and was having difficulty with the high-interest rates. Heim paid off the balance and arranged for the employee to pay her back at a more favorable pace and rate. Since then, Heim has offered dozens of loans to her employees for various reasons and found it made for happier, more productive employees.
“I’ve had positive outcomes,” said Heim. “I feel like the more I help my staff, the more they understand I’m going to be there for them. That’s worth it to me.”
Pros and cons of employee loans
Offering an employee loan is a decision that should be taken seriously, but that doesn’t mean there aren’t some compelling reasons to do it.
Financial issues such as general debt, medical expenses, education, or even basic living expenses can cause stress. As a result, this can make your employees less productive. Employee loans might help alleviate some of the stress so your staff can concentrate on their work. It’s one of the reasons Heim began offering loans to help staff who may be behind on bills. “I don’t want stressed out teachers,” she said.
Additionally, helping your employee out financially can build loyalty and boost your reputation as a workplace that cares about employees, which can help improve employee retention.
In any situation involving money, there can be complications. In some cases, these complications or concerns might mean that lending money to an employee is not the best idea for you or your business. Here are a few possible outcomes when giving out an employee loan:
- With any kind of loan, there is always a risk of being paid back late or not at all. Evaluate whether this is a risk you’re willing and able to take.
- If you offer one employee a loan, other employees may expect one as well. This could cause financial strain on your business.
- Employees who have received a prior loan from you may request more money down the road, try to negotiate a longer repayment term or reduce their interest rate.
- If the employee quits, it may be difficult to collect your money.
- There’s a real chance that owing an employer money might cause workplace friction.
Key considerations for employee loans
If you’re considering lending money to an employee, ask yourself the following questions before you proceed:
How will an employee loan affect your business taxes?
You may be hit with some extra taxes if you improperly issue a loan. To avoid this, make sure you offer clearly detailed loan terms and keep track of the Applicable Federal Rate (AFR). You can check AFR rates here. If your loan is over $10,000, you charge interest at the rate set by the IRS every month. If you don’t, the IRS may consider you to have received “phantom income,” which is taxable. You can find more information about how employee loans may affect your taxes through the IRS.
Are you prepared to set up formal lending arrangements for your business?
If you offer a loan to one employee, it’s unlikely they’ll be the last to ask for one. Having a general policy will help employees understand their financial options and limitations. A formal policy is a good place to clearly designate who has the authority to authorize a loan. Be sure to list the circumstances in which you will extend a loan and outline how quickly you expect to be repaid. Having a blanket policy can eliminate confusion and give employees honest information. It’s best to get ahead of this situation by creating guidelines for an employee lending program. That way, when an employee asks for a loan, you’ll already have a procedure in place.
How will you keep records?
Don’t be tempted to keep the loan “off the books” and always keep detailed and accurate records. That will help prevent your employee’s repayments from being reported as income.
What is your employee’s financial history?
How does your employee treat their finances? Are they a responsible money manager? Do you have any concerns about being repaid? What will they use the money for? All of these are questions you should consider when evaluating an employee’s financial situation. An employee who needs money for a one-time unexpected expense is very different from one who needs money because they can’t budget or live a lifestyle outside their means.
What’s included in the employee loan agreement?
If you are offering an employee loan, it’s essential that you have a promissory note drawn up. A promissory note is basically a legal I-O-U: a written promise that one party will repay another party a definite sum money. Issuing a promissory note makes you a lender. This agreement will outline the employee’s repayment terms, including payment amount, payment frequency, interest rate, and what happens in the event of default (for example, automatic deductions from the employee’s paycheck or legal action if the employee has quit). There are numerous templates available online for a promissory note agreement; however, it may be a good idea for your attorney to take a look at it.
State laws for employee loans
Employers in the United States can provide loans to their employees, but may have to comply with different laws depending on the state. Some states require employees to repay loans through payroll deductions, but only if it doesn’t dip below the federal minimum wage. Other states may require employees to authorize that kind of repayment in writing.
|State-by-state paycheck deduction laws on employee loans|
|State||Paycheck deductions permitted?||Website|
|Arizona||Yes, with written authorization||www.ica.state.az.us|
|California||Limited: California Labor Code prohibits deductions from pay without consent and for any reason other than requirement of law or collective bargaining.||https://www.dir.ca.gov/|
|Connecticut||Yes, with written authorization||http://www.ctdol.state.ct.us|
|Georgia||Yes, with written authorization||https://georgia.gov/popular-topic/georgia-law|
|Illinois||Yes, with written authorization||https://www2.illinois.gov/idol/Laws-Rules/|
|Iowa||Yes, with written authorization||https://www.iowadivisionoflabor.gov/|
|Kansas||Yes, with written authorization||https://www.dol.ks.gov/laws/|
|Kentucky||Yes, with written authorization||https://labor.ky.gov/standards/Pages/Wages-and-Hours.aspx|
|Louisiana||Yes, limits on interest rates||http://www.laworks.net/laborlawinfo.asp|
|Michigan||Yes, with written authorization||https://www.michigan.gov/lara/0,4601,7-154-59886—,00.html|
|Minnesota||Limited. Deductions cannot be used to repay a debt unless employee voluntarily authorizes it in writing or found liable in a court of competent jurisdiction||https://www.revisor.mn.gov/statutes/cite/181.79|
|Nevada||Yes, with written authorization||http://labor.nv.gov/|
|New Hampshire||Yes, with written authorization||https://www.nh.gov/labor/laws/index.htm|
|New York||Yes, with written authorization||https://www.labor.ny.gov/formsdocs/|
|North Carolina||Yes; deductions for interests and other charges related to loans require written authorization.||https://www.labor.nc.gov/workplace-rights/|
|North Dakota||Yes, except regarding undocumented cash payments||https://www.legis.nd.gov/cencode/|
|Ohio||Yes, with written authorization||http://codes.ohio.gov/oac/|
|Oregon||Yes; employer must provide an itemized statement with amount and purpose of deduction.||https://www.oregon.gov/boli/TA/Pages/TA_FAQ_Itemized_Statements.aspx|
|Rhode Island||No information*||http://www.dlt.state.ri.us/|
|South Carolina||No information*||http://www.llr.state.sc.us/|
|South Dakota||No information*||http://dlr.sd.gov/employment_laws/wage_hour_issues.aspx|
|Texas||Yes, with written authorization||http://www.twc.state.tx.us/jobseekers/employee-rights-laws|
|Utah||Yes, with written authorization||https://laborcommission.utah.gov/|
|Virginia||Yes, with written authorization||https://www.doli.virginia.gov/laborlaw/|
|Washington||Yes, with written authorization||https://www.lni.wa.gov/|
|West Virginia||No information*||https://labor.wv.gov/Pages/default.aspx|
|Wisconsin||Yes, with authorization||https://dwd.wisconsin.gov/er/labor_standards/labor_standards_laws.htm|
*States with no information might not have any applicable state law, or they may just follow federal law in this area.
Alternatives to employee loans
If you’ve decided that giving your employee a loan isn’t right for you, that doesn’t mean you’re out of options to offer financial assistance. There are some alternatives for financial aid that might be a better fit than a loan.
1. Loans from retirement plans
A loan from an employee’s 401(k) might be a good option. People can borrow up to 50% against an account balance, up to $50,000. This plan will charge a reasonable rate of interest, and repayment must be within five years (the only exception to this is for buying a home). However, if the employee leaves the job, they’ll have to repay the loan in full, otherwise their outstanding balance will be treated as a taxable distribution. If the employee is under the age of 59 1/2, the distribution is also subject to a 10% penalty. If this option seems like something you may want to explore, the IRS has more information.
2. Paycheck advance
Do you have an employee who needs fast access to money? Sometimes emergency expenses, like sudden medical costs or urgent car trouble don’t actually require a loan. A paycheck advance might be a good solution if your employee is hitting a financial rough patch because they have expenses they can’t pay until they have their next paycheck.
Tiana Kubik of TK Photography in Chicago, offered to advance the pay of one employee who was undergoing treatment for a medical condition. “She didn’t ask — we offered because we knew the situation she was going into,” Kubik said. “I think it made her feel cared for, that we wanted to make sure she had a paycheck not only when she was on the clock but when she wasn’t working, too.” This gesture affected not only the employee in question, but the rest of the staff as well. “I think it did a lot for the morale in the office,” said Kubik.
To repay the advance, a small percentage was deducted from the employee’s paycheck until the balance was paid off. “We wanted to make sure that she had enough to live on,” she added. Kubik said she would consider future advances or loans, depending on the employee.
Advancing a paycheck is a simple answer for a short-term financial need that’s dependent on the timing of cash flow. This solution can also reduce your business’s potential loss to the amount of one paycheck and is less complex than a formal loan agreement.
Only you can decide whether or not it’s a good idea to lend your employee money. The best plan is to educate yourself about employer loans, potential complications, key considerations and alternative options. Having all the information will help you find a solution that works for you, your employee and your business.