By: Martin M. Shenkman, CPA, MBA, JD
A father loans his son money to start a business. A brother loans his sister the down payment for her new home. Family loan transactions are common. But too often, their frequency makes families complacent about the numerous, and potentially costly tax implications of these “simple” transactions. This article will highlight many of the important issues involved.
Family loan transactions are often sizable transfers — a tad more than envisioned in the 1931 classic song, "Brother, Can You Spare a Dime." A threshold issue is not knowing what kind of transfer is it; is it a loan, or a gift? This is a big issue. If the transfer of funds is a gift, to the extent it exceeds the annual $12,000/donee gift tax exclusion, it will erode your $1 million lifetime gift exclusion, and beyond that amount will trigger current gift tax cost. Ouch! If the transfer is a loan, on the other hand, you will avoid current gift tax issues, but have to contend with a confusing web of income tax rules.
The tax laws view a “gift” differently then the typical person would; no boxes and bows required. If you make a transfer for less than full and adequate compensation, you have made a gift. Intent is generally irrelevant. In the context of a family loan it is presumed that a transfer of money to a family member is a gift, and not a loan. Harwood v. Comr., 82 TC 239 (1984). You can rebut that presumption if you can demonstrate that you had a real expectation of repayment.
To assure that the transfer is treated as a loan and not taxed as a gift, you should do each of the following:
While not all factors have to be present for the IRS to respect the transaction as a loan, the more the merrier.
While you may be tempted to give Junior a break on the interest he has to pay you on the loan, charging less than the current interest rate has a tax consequence. IRC Sec. 7872. The determination of the minimum required interest rates, called the Applicable Federal Rate (AFR) is made under Code Section 1274(d) which provides for different interest rates depending on the term of the loan. These rates are updated monthly and are based on the average yield of Treasury securities. Special rules are provided for demand loans (loans without a set maturity, which are due when the parent/lender demands repayment). If you charge less than the mandated interest rate, the undercharge is deemed a gift from you to Junior which could trigger a tax cost if in excess of the annual gift tax exclusion amount. The computation is actually based on determining the present value of all interest and principal payments using the AFR as the discount rate. The interest undercharge you gifted to Junior is then treated as if Junior paid it to you as interest and you have to report the amount as interest income. Junior might qualify for an interest deduction. IRC Sec. 163.
Exceptions to Interest Imputation
There are a number of exceptions when the above interest imputation rules don’t apply. If the money you loan is not invested by Junior and is not more than $10,000, interest does not have to be imputed. If the loan is not more than $100,000 and Junior’s net investment income is note more than $1,000, the rules do not apply for income tax purposes. Special rules apply to a sale of land between family members for $500,000 or less and other transactions. IRC Sec. 483.
Types and Uses of Family Loans
Family loans can come in a wide array of forms, and can be used to accomplish a many different goals. If the transfer of funds to Junior is properly structured as a loan, it can provide significant tax and economic advantages to the family.
A loan can protect the family funds if Junior divorces. The loan gives you a claim on the principal.
If Junior can earn more on the loan than the interest he has to pay, the excess earnings are effectively transferred outside the parent/lender’s estate. For example, if mom finds an interesting real estate project, rather then her buying she can permit Junior to buy the deal, and she can loan him the funds to do so. This avoids having to include the property and the anticipated substantial appreciation from the deal from her estate. (However, keep in mind that the recent expansion of the Kiddie tax can result in Junior paying tax at your bracket even at age 23!) While this planning still makes sense to shift value to Junior free of gift tax, the Kiddie tax lessens the benefits.
A common application of these rules occurs when you help Junior buy his first house. Given the present issues in the mortgage market, you might be able to give Junior a loan for less than he could secure from an independent lender, if he can even obtain a loan now. You can charge Junior less than a bank would, with the amount that you charge still possibly exceeding whatever you might earn investing the funds. While the imputed interest rules may apply, they might only lessen the overall family benefits, not eliminate them. If you do engage in such a transaction, evaluate the benefits of actually recording a mortgage on Junior’s house to secure your loan in the event Junior’s business or marriage goes bust.
Another common loan transaction is your sale of FLP, LLC, or family business interests to a grantor trust in hopes of removing future appreciation from the estate. Given the dollar size of these loan transactions, additional care and precaution to meet the above loan criteria, as well as other steps are in order. When the loan is used in a sale transaction, such as between a family member and a family trust or partnership, greater care should be taken. The courts don’t always look favorably or leniently on intra-family loans. See Estate of Rosen v. Comr., T.C. Memo 2006-115. In these types of loan transactions, you might want to add additional steps such as some capitalization of the borrower to support the loan, representation by independent counsel, etc.
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