Planning and Traps

Dad loans son money to start a business. Brother loans sister the
down payment for her new home. Family loan transactions are common. But to
often their frequency makes families complacent about the numerous and
potential costly tax implications of these “simple” transactions. This article
will highlight many of the important issues involved.

Family Loans
Introduction:

Family loan
transactions are often sizable transfers. A tad more than envisioned in the
19310 classic song “Brother, Can You Spare a Dime”. A threshold issue
is what is the transfer? Is it a loan or a gift? 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 you’ll avoid current
gift tax issues, but have to contend with a confusing web of income tax rules.

Gift or Loan:

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 consideration, you’ve
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, 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.

Steps to
Assure a Loan:

To assure that
the transfer is treated as a loan and not taxed as a gift you should do each of
the following:

• Have a written
loan document (e.g., a signed promissory note).

• The borrower
should be solvent when you make the loan (get a copy of Junior’s balance
sheet).

• Charge interest
(more on this below).

• Junior should
make payments as required under the loan documents. Save copies of the
cancelled checks.

• Your tax
return, as well as Juniors, should report the transaction consistent with the
position that a loan was made. The transfer is not reported as a gift; you
report interest income; Junior reports interest expense.

• If Junior
misses a payment date, or does not repay on maturity, then you must demand
repayment. You really want to treat it no differently than a loan to a
stranger.

• Include a fixed
repayment schedule. While a demand loan should be respected, a payment schedule
may prove easier to defend.

• Don’t plan in
advance to forgive any of the loan. A letter to Junior that he’ll never have to
pay and you’ll forgive $12,000 of the loan each year using the annual gift
exclusion, may torpedo your loan. Although some courts have respected forgiving
portions of a loan as qualifying for the annual gift exclusion, the practice
might contradict the position that the original note was ever intended to be
respected and repaid. Rev. Rul. 83-180, 1983-2 C.B. 169.

While not all factors have to be present for the IRS to respect the transaction
as a loan, the more the merrier.

Interest Rate
on the Loan:

While you may be
tempted to give Junior a break on the interest he has to pay you on the loan,
charging less then 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, but rather 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 won’t 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 be used to accomplish a wide array of
purposes. If the transfer of funds to Junior is properly structured as a loan
it can provide significant tax and economic advantages to the family.

Divorce Protection:
A loan can protect the family funds if Junior divorces. The loan gives you a
claim on the principal.

Wealth Transfer:
If Junior can earn more on the loan then 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 including the property and the anticipated substantial
appreciation from the deal from her estate. However, 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.

Home Down payment:
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 then he could secure from an independent lender, if
he can even obtain a loan now. You can charge Junior less than a bank would.
The amount you charge may still exceed 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.

Family Sale Transactions: 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.