On occasion, an employee may experience serious financial problems and share them with you—the boss and small business owner. Many employees are still reeling from COVID-19-related problems and now, with high inflation, may face new financial challenges. For owners, being compassionate is a good quality, but also be aware of some issues if you want to help.
An employee may request a cash advance against an upcoming paycheck. In essence, you’re fronting them the money before they actually earn it. It’s like a short-term loan, but no interest is charged. You are under no obligation to make this advance. If you want to do so, consider:
- Have a written policy about paycheck advances. The policy can set limits (e.g., maximum advance amount, how often an employee may obtain an advance). The policy should also make it clear whether repayment will be done via payroll deductions (the usual method) or additional payments by the employee to the company. Be sure the paycheck advance policy is nondiscriminatory, so if you give an advance to one employee, you must do so for others subject to the terms of the written policy.
- Put it in writing. When you make an advance, have an employee sign a statement specifying the terms. For example, spell out that $XX amount will be deducted from upcoming paychecks until the advance is effectively repaid.
- Understand minimum wage rules. Payroll deductions for repaying cash advances do not violate federal minimum wage rules. However, if there are any costs to the employee for obtaining an advance (e.g., bookkeeping fees), they may NOT lower a paycheck below minimum wage.
Loans to employees
Perhaps a payroll advance is too small for an employee’s needs in a particular situation. For example, during COVID-19, an employee in an electrical company needed $5,000 to move his family to new quarters, and the employer was able to comply. In making loans to employees, keep these factors in mind:
- A written promissory note is essential. The note spells out the details of the loan: the principal of the loan, the interest charged for loan, repayment dates, etc. Caution: Loans to minimum wage employees that are repaid via payroll deductions and entail interest may not reduce a current paycheck below minimum wage on account of the interest.
- Watch below market loan rules. You must charge an interest rate at least equal to the Applicable Federal Rate (AFR) for the period of the loan (e.g., short-term, mid-term, long-term). If you don’t, the spread between the interest charged, if any, and the AFR is taxable compensation to the employee and subject to payroll taxes.
- Employees may not be able to repay the loan. In some cases, they may leave the company with an outstanding balance. Sure, you can try to track them down and collect. Realistically, it’s better for an employer to make the loan with the knowledge that it may or may not be repaid. Be sure your cash reserves are sufficient to support a loan.
Other financial assistance
Without taking any money out of the company coffers, you may still be able to provide some help to financially strapped employees if they participate in a qualified retirement plan.
- Loans. An employee may borrow up to 50% of his or her account from the company’s 401(k) plan, up to a maximum loan of $50,000. The plan must permit the borrowing and require repayment over a period not exceeding five years (longer if borrowing is to buy a home). The IRS has more information about plan loans.
- Hardship distributions from qualified retirement plans. Plans may permit distributions on account of a severe and immediate financial hardship—such as paying for a funeral of a spouse. The distributions are taxable to employees and, if under age 59½, may be subject to a 10% penalty (unless a penalty exception, such as paying certain medical expenses) applies. The IRS has more information about hardship distributions.
Companies may want to offer financial literacy help to employees, encouraging them to save money and create an emergency fund, as well as learning about budgeting, managing debt, and investing. While the employer does not have to act as instructor, the company can arrange for lunch hour or after-hours information from the company’s CPA, a firm that the company already works with (e.g., an insurance company or brokerage firm), or a company specifically providing financial fitness programs (e.g., Financial Fitness Group).