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Financial
Planning for Your Business' Stage of Life |
If
you have healthy finances and your family members don’t,
making intrafamily loans might seem like a good idea. But intrafamily
loans can carry substantial negative tax consequences —
such as unexpected taxable income or gift tax or both.
Intrafamily loans made at below-market interest rates can raise
the reddest of flags. If you make a sizable loan, you may have
to report taxable interest income even if you didn’t charge
any. And if you report taxable interest income, the borrower
may not be able to deduct the hypothetical interest expense.
Ill-planned intrafamily loans can also trigger the gift tax.
In addition to the loans themselves, foregone interest and forgiveness
of bad debts can create gift tax, because the IRS may consider
these items as income to the recipient.
Here are seven tips for avoiding tax traps on intrafamily loans.
Tax Tip 1: Leave a Paper Trail
When lending money to family or friends, leave a solid paper
trail. An informal intrafamily loan may have unpleasant consequences
if the lender dies. For example, Monty lent his son $75,000
but died before Michael made any payments. Because Monty failed
to document the loan, it wasn’t deducted from Michael’s
share of the estate. Other family members — who knew about
the loan — were upset that the loan was forgiven because
Monty didn’t keep any loan records. To make your intentions
clear — and avoid loan-related misunder-standings —
document the loan and payments received.
Of course, other important advantages flow from good loan documentation.
If you should later need to write off an intrafamily loan as
a bad debt, you’ll need to show that the loan was bona
fide. To decide whether a debt is bona fide, courts consider:
| • |
Written
evidence of the debt |
| • |
Interest
charged |
| • |
Fixed
repayment schedules |
| • |
Collateral |
| • |
Demands
for repayment |
| • |
The
borrower’s intent to repay and sol-vency at the
time of the loan |
| • |
Payments
made |
Tax Tip 2: Use the Annual Gift Tax Exclusion
Say you want to help your daughter buy a house, but you don’t
want to use any of your lifetime estate and gift tax exemption.
Make the loan and then forgive the interest, the payments —
or both — each year under the annual gift tax exclusion.
You can forgive up to $10,000 a year ($20,000 if your spouse
joins in the gift) without paying gift tax or using your lifetime
exemption. But you’ll still have interest income in the
year of forgiveness.
Tax Tip 3: Show that You Intended to Collect the Loan
Even if you plan to use the gift tax exclusion to forgive the
interest and/or payments each year, have the borrower make some
payments. By showing at least some repayment history, you’ll
make it harder for the IRS to argue that the loan was really
an outright gift. And if a would-be borrower has no realistic
chance of repaying a loan — don’t make it up. If
you’re audited, the IRS likely will treat such a loan
as a gift especially if you never intended for the borrower
to repay the loan.
Tax Tip 4: Forgive or File Suit
If the borrower defaults on an intrafamily loan that you intended
to collect, don’t let it sit too long. If you want to
prove this was a legitimate loan that soured, you’ll need
to take appropriate legal steps toward collection. But if you
know you’ll never collect and can’t bring yourself
to file suit, you can try forgiving the loan over time using
the $10,000 annual gift tax exclusion.
Tax Tip 5: Charge Interest if the Loan Exceeds $10,000
If you lend more than $10,000 to a friend or relative, charge
at least the applicable federal interest rate — currently
just under 6% on long-term loans. Otherwise, the IRS will treat
foregone interest as income to you and as a gift to the borrower,
under complicated rules that require the imputing of interest
on below-market-rate loans.
Tax Tip 6: Watch Out for Loan Guarantees
If you think you might avoid all these rules by simply guaranteeing
rather than making a loan — beware. The IRS views loan
guarantees as transfers of economic value. In other words, the
IRS may consider it a gift subject to gift tax — which
it determines case by case.
Tax Tip 7: Check the Rules
The best loan structure and lending strategy depends on your
situation’s specifics and loan. For example, you may escape
imputing interest income on loans to individuals less than $100,000
if the borrower has no net investment income.
If you’re considering lending money at below-market rates
or guaranteeing a loan, give us a call. We can help you evaluate
the income and gift tax consequences — for both you and
the borrower.
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