Danny mentioned that he talked to some co-workers who told him that the IRS is always skeptical of loans between friends and family and tries to tax them as gifts. To avoid this, he thinks it is important to use the minimum IRS-set interest rate, which is 3% per year. He felt a little strange about charging his sister interest, but they wanted to go about this the right way.

The next item to discuss is how the LLC will pay back the loan. There are a few different options for this: installment payments, a lump sum payment, a combination of the two, or a lump sum payment in-kind (meaning the payment would be in goods or services, rather than cash). After going through the benefits and drawbacks of each option, and deciding that $20,000 worth of cheese would be too much for Danny to handle, the Earth siblings decided that an installment with a lump sum payment is the right way to go. This option allows for the fluctuation in income that the farm has de- pending on the season. The smaller installments will allow Susie to lower the amount of the loan slowly over time, and when she makes a big sale she can pay off the entirety of the loan. Danny was careful to point out that in order for the promissory note to be effective, Susie would have to be sure about when she will be able make the lump sum. Susie was confident that she will be able to do so in three years.

Danny and Susie ran through a couple other scenarios, hashing out what might happen if Susie wants to pay the loan off early, or in the opposite scenario, can’t pay it off by the time she thought she could. Tensions rose during these conversations, and Susie realized how important it is to be talking about these details beforehand. She specifically got defensive when Danny brought up the idea of including an acceleration clause in the note–if Susie is later than 30 days on the loan or the LLC becomes insolvent, then the entire amount of the loan becomes due right away. Susie thought this sounded harsh and was offended that her brother would impose such strict terms on her. Danny tried to calm Susie down by explaining that this is just a protection in case Susie continually misses her payments. Danny would have to choose to enforce the acceleration clause, and if he doesn’t accelerate than the note would just continue as a contract between Danny and the LLC. Susie agreed and trusts her brother would use his discretion and not be so harsh if Susie got into a bind.

Next, they discussed whether the loan will be collateralized to make it a secured loan. Danny explained that most commercial loans require the borrower to put something up–such as land, equipment, or a car–as collateral to secure the loan. Should Susie miss a payment, Danny could get his hands on the collateral–but only take the value of what is owed on the loan and Susie would get the rest. Danny suggested that they make this a secured loan, and use the property that Susie was purchasing as collateral. He explained that otherwise a court could conclude that the promissory note is a “security,” and Susie would have to comply with all kinds of complex state and federal securities laws. Danny assured her that it would only happen if she couldn’t make the payments on time. Susie agreed that this is fair. After all, while she hopes it doesn’t happen, if a scenario does arise when she can’t make the payments, it likely means that things aren’t going so well. It may be better to just sell the property so she can make due the payments she would owe to her brother and invest the rest back into the farm business.