Potential Legal Implications of the Promissory Note
The Promissory Note is a valuable tool used by individuals and businesses alike to lend and borrow money outside the parameters of traditional financing through a bank. Promissory Notes are often made for investment purposes but can also be used for personal reasons, to provide financing when funds are needed. A Promissory Note contains an individual’s written promise to pay another party a definite amount of money. It should also include the interest rate (if any), maturity date, date and place of issuance, and the party’s signatures.
A Promissory Note is clearly beneficial to the borrower, but it can also be a source of income for the lender in the form of interest on the amount borrowed. However, individual and small business lenders should be wary of the potential pitfalls of the Promissory Note. Two common pitfalls include (1) the failure to pay taxes on the amount earned under the Promissory Note and (2) unfamiliarity with Texas usury law, prohibiting the lender from charging too much in interest.
The Tax Problem
The income generated by a Promissory Note, namely the interest collected on the borrowed amount, is taxable income for IRS purposes. The income is the interest earned by the lender on the Promissory Note for the tax year in question. Very often, payments from the borrower on the Promissory Note do not separate the principal from the interest amount, so it is important to determine what portion of each payment is part of the taxable income. If you, as the lender, loaned personal money, the income needs to be reported on your personal tax return.
The Usury Pitfall
Usury occurs when a lender exacts from the borrower a greater compensation for use of the money than allowed by law. Essentially, the State of Texas sets limits for allowable interest rates, and usury occurs when a lender charges an interest rate in excess of those limits. For example, many hasty lenders will write a 50% interest rate into a Promissory Note, with the expectation of making a large profit on their generosity. However, for contractual agreements like the Promissory Note, a 50% interest rate is illegal, and the punishment for violating Texas usury laws can be steep.
The applicable interest rate ceilings in Texas are as follows:
- If the Promissory Note does not specify an interest rate, a lender can still charge an interest rate under Texas law of 6% per annum beginning on the 30th day after the sum is due and payable.
- A lender may charge an interest rate of up to 10% per annum if the rate is specified in the Promissory Note.
- And in certain instances, the applicable rate can be as high as 18% per annum. Certain creditors are completely prohibited from charging a rate higher than 10%.
Lenders are often unaware of interest limits, which can subject them to liability for three times the excessive interest amount received or 20% of the principal amount. Thankfully, there are ways to retroactively cure usurious interest. There are various requirements and timelines for curing such a usury violation, and they depend on whether the lender discovered his violation before the borrower discovered it. All cures, however, involve written notice and correction of the violation, which may include refunding the excess money collected.
Cure notices need to be sent shortly after the discovery of the usury violation, and they should be carefully drafted to meet the requirements of the Texas Finance Code. Experienced attorneys at Waldron & Schneider, PLLC can review Promissory Notes and Loans to ensure compliance with the law.
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