Tax Planning and Compliance
Interest Free Loans Between Family Members
Family loans are a common thing. Particularly common are parent loans to children. Parents often charge little or no interest for such loans. Even where interest is required on paper, many parents do not actually require children to pay the interest when due. Properly administered family loans can be a very effective estate planning tool, transferring wealth to children or later generations gift and estate tax-free. However, if not properly administered, family loans may very easily trigger adverse tax consequences, including penalties and interest.
In 1984, the U.S. Supreme Court determined that the interest-free use of money constituted a gift for federal gift tax purposes. Thereafter, Congress enacted a tax provision which reaffirms that interest-free or below market rate loans are taxable transfer, both for income and gift tax purposes.
When a person makes an interest-free loan, the law imputes two (2) transfers that do not actually occur: (i) a gift transfer from the lender to the borrower of the foregone interest, and (ii) the payment of interest by the borrower to the lender.
The full value of the foregone interest is treated as a taxable gift to the borrower. The amount changes based on the interest rate that applies. The IRS sets the “applicable interest rate” for such gifts based on the length of the loan. The applicable interest rate is promulgated by the IRS in a monthly publication. For example, for June 2011, the IRS applicable rate for long-term loans (i.e., more than 9 years) with interest payable annually is 4.05%.
To calculate the gift tax due, the lender is treated as transferring cash in the amount of the excess of the amount lent over the present value of all payments required under the loan (calculated using the applicable interest rate in effect at the time of transfer). This is the gift amount. This amount is then treated as retransferred by the borrower to the lender over the course of the loan period. This is the lender’s income amount.
For example, an interest-free loan of $100,000 may be treated as the equivalent of a $75,000 loan at the prescribed applicable interest rate. The $25,000 would constitute the amount of the immediate gift. This $25,000 amount is then treated as retransferred by the borrower to the lender as interest paid over the loan period.
This second segment of the transaction will produce interest income to the lender, taxable at ordinary income rates. The deemed payment may also produce an interest expense deduction for the borrower, but the deductibility is dependent upon the borrower’s use of the funds. Failure of the lender to report the interest income may result in IRS imposed penalties and interest.
There are two (2) general exceptions for the requirement to charge and report interest in family loans. The first exception is where the amount of all combined parent loans to a child does not exceed $10,000. This exception does not apply, however, where the loan money is used to purchase or carry income-producing assets.
Second, where the loan is less than $100,000, the amount of the imputed interest may be limited to the borrower’s net investment income for the year. If the borrower’s net investment income is less than $1,000, the imputed interest on the loan is zero. However, this limitation does not apply where one of the principal purposes of the loan is to avoid federal taxes.
In sum, family interest-free or below market rate loans can be very complicated tax-wise. The main goal of the IRS is to curb abuses by imposing the results of what would normally take place if the parties dealt with each other on an arm’s-length basis. Failure to properly document the loan, charge the proper rate of interest, receive actual interest payments, and report interest income, may result in severe penalties.
Again, properly administered family loans can be a very effective estate planning tool, transferring wealth to children or later generations gift and estate tax-free. If you plan to make loans to family members, or if you have already, please contact us today so we can help you ensure the loans are properly documented, administered, and reported for tax purposes.