Many of us have helped a family member or friend before by providing an interest-free loan. Although the loan is not intended to be a gift, the details may not have been formalised and there may be no stipulation as to when and how the loan must be repaid.
A similar situation occurs where a director provides a loan to his or her company or a family member lends money to a family trust without formally documenting the transaction or specifying a repayment date.
A loan falling in these categories is considered a ‘loan payable on demand’.
Despite good intentions between the lender and borrower, these types of loans may create unintended and adverse consequences.
This article identifies some of the potential pitfalls of informal loans or loans payable on demand, particularly those made to family or friends.
If you have made an informal loan to a friend, relative, family company or trust, the interplay of these two legal rules must be considered:
The effect of these principles means that, because a loan payable on demand creates an immediate legal right for the lender to sue from the time the money is advanced, the limitation period is triggered at this point and the lender will only have six years from that time to pursue the borrower for the debt.
To the unwary, making an informal loan may not seem a big issue. However, the way our laws interrelate may prevent the lender from ever recovering the loan. The following typical scenarios between family members illustrate some of the issues that can arise.
The loan is not formalised and, although a repayment date is not set, the loan is not intended to be a gift. The child and spouse purchase a home and, eight years later, separate and commence property settlement proceedings. In this case, the debt becomes legally extinguished and the child’s estranged spouse may claim that the money was a gift.
Unless it can be shown otherwise, the loan will form part of the pool of assets and liabilities to be divided and distributed under family law legislation. The loan will not be legally recoverable by the parents and the estranged spouse may choose to ignore it.
The loan is not documented and there is no stipulated date for repayment. Seven years later, business is going well, but the loan remains unpaid. The widow has a Will leaving her entire estate, valued at $600,000 equally to her four children. The widow dies, and the other three children contend that their mother always wished for her children ‘to benefit equally’ and that the loan of $100,000 should be repaid to the estate and accounted for in the distribution between the four children.
As the limitation period has expired however, the estate has no legal right to recover the loan. Unless agreement is reached, each child will receive $150,000 each however the child who borrowed the money will have the benefit of the additional $100,000 loaned.
The loan is not documented. The son is notorious for his impetuous ‘whims’ and risky business decisions. The loan will become unenforceable after six years. Should the son become bankrupt after that time, then the parents will be unable to prove or recover the debt (or portion of it) from any available assets in bankruptcy proceedings.
If you propose lending money, whether to a family member, a friend or a family company it is important to have a written deed or loan agreement in place. The agreement should specifically state that the loan will become payable at a future date. In this case, the limitation period will not be triggered until a demand for payment is made.
Your lawyer can assist in preparing the deed or agreement to ensure that the limitation period will not be triggered as soon as the money is advanced. He or she can also flag any other potential issues and help you understand your rights and protect your interests under the agreement.
If you have already loaned money without formalising an agreement, you may still be able to exclude application of the six-year limitation period by obtaining a confirmation of the loan or requesting the borrower to enter into a loan agreement.
Legislation in each jurisdiction has provisions enabling the limitation period to ‘re-start’ upon acknowledgement or confirmation by the borrower of the debt. In New South Wales, confirmation must be received before the expiration of the six-year limitation period and is established by the borrower either confirming the debt in writing, or making a payment of principle or interest under the loan. The limitation period is reset from the time that the confirmation is received.
Timing as to when confirmation may be obtained, and the evidence required to establish acknowledgement of a debt varies between jurisdictions. Your lawyer can explain the applicable rules in your area.
Loans made informally without a fixed date for repayment can lead to unintended consequences – if a lender decides not to request repayment of the loan within six years after it is made, it may become impossible to recover the funds.
If you are in a position to help out a friend or family member by lending them some money, that’s great news. But be aware, a loan that falls into the legal definition of a loan payable on demand, may become a loan never repayable!
All financial transactions, even the ‘friendly’ ones, should be in writing to ensure that the parties are aware of their obligations and the lender is properly protected.
If you or someone you know wants more information or needs help or advice, please contact us on (02) 9274 8820 or email firstname.lastname@example.org.