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The New York Times

Loans From a Bank Supported by the Family Tree

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MANY 20-somethings with a business idea — or a gap between their income and their living expenses — turn to the bank of mom and dad for help. This is hardly new, even if the numbers are increasing.

But a subset of parents, many quite wealthy, is responding not with handouts but with loans that children apply for and that require approval by parents, relatives, or even people outside the family, as they would at a bank.

These families are working to support their children’s interests without robbing them of motivation, causing rifts among their siblings or even running afoul of the Internal Revenue Service, which may wonder whether these loans are really gifts.

“My advice is to start early and small and allow it to grow,” said Warner King Babcock, chairman and chief executive of AM Private Enterprises, a registered investment adviser in New Canaan, Conn.

Mr. Babcock, a chemist by training, knows whereof he speaks. When he was in his early 20s and working for his father’s engineering and construction materials company in Greenwich, Conn., he got an idea for a type of waterproofing that would work in extreme conditions. His father backed the idea financially, and Mr. Babcock patented and began selling the coating.

The company sold its high-performance coatings to clients like zoos and nuclear power plants. But seven years into the venture, Mr. Babcock told his father that he was leaving, even though the company was doing well.

Today, he chooses his words carefully so as not to offend his siblings.

“I felt early on that I had a lot of freedom and I was empowered to grow the firm,” he said. “As time went on, I felt that there was more involvement in the key decisions, and it got to a point where that caused friction. If there was an outside board that could have acted as a buffer, that would have helped.”

That experience informed his later work as an investment adviser to large, wealthy families.

Mr. Babcock is trying to share the benefits and perils of what is often called the family bank with a wider audience. In this, he is part of a small group of advisers that sees formal lending in a family as a way to invest in ideas from younger generations, provide financing when real banks may be hesitant and teach lessons about stewardship and responsibility.

Here’s some of what families of more modest means can learn.

HOW TO DO IT RIGHT Parents hardly need to be told that their children are having trouble supporting themselves after finishing school. But a recent report from Junior Achievement and the Allstate Foundation said that the number of high school students expecting to be financially dependent on their parents into their late 20s had more than doubled in the last two years, to 25 percent from 12 percent.

According to the report, parents have also resigned themselves to offering some level of financial assistance through those years. The parents cited the poor job market and economy, and changing societal norms.

This is where loans in a family may be a way of supporting a child’s idea without making it seem like a handout.

Whether a family is making a $10,000 or a $1 million loan, the most successful lay out criteria for lending. They could say that loans will be made for business ventures, investments or a mortgage on a house, but not for living expenses or travel. They could require everyone to submit a business plan.

“If you have a family bank set up where there is a system or a process for asking the family for loans, it cuts out all the issues of people asking for money and saying you like my sister better,” said Mindy Rosenthal, president of the Institute for Private Investors, an organization that recently hosted a seminar on the Web about family banks. “All the processes and procedures cut out all this family dynamics.”

From there, the loan should include language explaining that it must be repaid and what will happen if the endeavor fails.

Mr. Babcock said he knows of one family that requires collateral before making a loan. Others, he said, require periodic updates on the business and reserve the right to offer advice or renegotiate loan terms if the business is struggling. If the loan can’t be repaid, Mr. Babcock said a family that had documented it could write it off the way a bank would.

HOW IT GOES WRONG As with anything in a family, there are many ways that lending money to relatives can end badly.

Mr. Babcock said he would never advise a highly dysfunctional family to create a family bank. If family members could not communicate civilly, then lending money would just add to the conflict.

There are also legal requirements. The I.R.S. has guidelines on how much interest needs to be charged, depending on the length of a loan. Known as the applicable federal rate, or A.F.R., the interest is low — about 1 percent for loans from three to nine years — but the I.R.S. expects parents to collect it.

These guidelines cover documentation, too. If there was not a real loan agreement or interest charged, the I.R.S. could say that the loan was really a gift and levy gift taxes, interest and penalties on it, or it could say that a loan that was forgiven when a business failed was actually income for the recipient.

“The I.R.S. assumes intrafamily loans are disguised gifts,” said Thorne Perkin, managing director at Papamarkou Wellner Asset Management. “You need to document these things. You need to set up a payment schedule. You need to use something above that A.F.R. rate.”

Mr. Perkin said parents often use their annual gift exclusion, now $14,000, to forgive interest, and many loans are structured to be interest-only with the principal due at the end. Still, it is important to have documents in place.

Another risk is that such low rates for intrafamily loans push parents to make loans without thinking about the consequences.

“We generally make sure that the client can afford to lose the liquidity of the assets, and that they’re working with their accountant and attorney and understand the tax consequences of doing so,” said Ann D. Bjerke, senior wealth strategist at UBS Financial Services.

The interest on the loan, for example, needs to be claimed as income by the lender.

LESSONS BEYOND THE LOAN Helping children is at the heart of these loans. But if done right, they can do a lot more than provide low-interest financing that a bank might not approve.

One is increasing children’s understanding of finance and lowering their sense of entitlement, said Richard Orlando, president and chief executive of Legacy Capitals, a family consultancy.

“Raising their financial I.Q. helps the next generation apply for loans, put together business plans and pay back loans,” he said. “It also teaches them about being responsible, doing their homework, and collaborating with other members to get loans.”

Just as important, a family bank with set lending criteria can help parents step out of the process so that their children have to present their plans to a board that might consist of family attorneys and advisers. The board could challenge the children without stirring up family resentments.

Mr. Babcock said parents can also decide to create a soft bank with an intent to educate their children. Whereas a hard bank would manage the loans for profit, almost as alternative investments in a family’s portfolio, a soft bank would look at the loans as a way to develop the human capital of their children. One way might to be invest in a child’s floral shop, with an understanding that it could fail but would teach business lessons along the way.

“Money can do a lot of things,” he said. “But the last thing parents want it to do is create bad behavior patterns from a young age.”