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March 2005 Avoiding the tax risk of loans to family, friends, businesses Charging below-market interest requires you to walk a virtual tightrope The same upfront planning that is essential to warding off unexpected tax consequences when you make loans to relatives applies to loans you make to friends and to related businesses. (The main difference: After the loan is repaid – or not – your relative will still be your relative.) A key factor in how you structure the loan is the amount of interest you want to charge and your borrower is willing to pay. In many cases, loans between family members are below-market loans. By that, we mean the lender charges either no interest or a rate below the Applicable Federal Rate (AFR).
The relevant AFR for a particular loan is the one in effect for loans of that duration for the month the loan is made or for any of the three preceding months. The AFR applies to the life of the loan, regardless of interest rate fluctuations during that time. The exception is demand loans, for which the AFR is recalculated annually by “blending” the monthly short-term AFRs for that year. As long as you charge interest at or above the AFR, you should be relatively free of income tax and gift tax concerns. However, if you want to live life on the edge, i.e., charge less than the AFR, read on. When you make a below-market loan to a relative or any other non-business party, the Code treats you as making an “imputed gift” to your borrower. Business-related loans follow similar concepts, except the offset is not a gift; instead, it is compensation or a capital-related item. The “deemed” gift you make equals the difference between the AFR interest you should have charged and the interest you actually charged. The borrower is then deemed to pay these phantom dollars back to you as “imputed interest,” and you must report the imputed interest as taxable income. To make matters worse, when your imputed gift to the borrower exceeds $11,000, you will owe gift tax if you have exhausted your lifetime exemption. You can usually avoid these negative tax outcomes by taking advantage of two big exceptions. The “$10,000 Rule.” For small loans, the IRS lets you ignore the imputed gift and imputed interest income rules. However, the total of loans between you and the borrower must be $10,000 or less. Note that the $10,000 aggregate loan limit applies to all outstanding loans between you and the borrower, whether or not you charged interest equal to or above the AFR. The “$100,000 Rule.” Obviously, the $10,000 rule is no help with bigger loans. Fortunately, in many cases, the $100,000 rule will keep you out of trouble. You are eligible for the $100,000 rule as long as the aggregate balance of all outstanding loans (below-market or otherwise) between you and the borrower is $100,000 or less. For income tax purposes, the taxable imputed interest income to you is zero, as long as the borrower’s net investment income for the year is no more than $1,000. (Net investment income is the same figure used to determine how much broker margin account interest can be deducted currently on your itemized deduction Schedule A.) If the borrower’s net investment income exceeds $1,000, your taxable imputed interest income is limited to no more than his or her actual net investment income. The borrower must give you an annual signed statement disclosing his or her net investment income for the year. Be sure to keep this document with your tax records. Gift taxes. Although these exceptions address the matter of income taxes, gift issues remain. For gift taxes, the $100,000 rule can be tricky. You should designate your below-market or interest-free loan as a demand loan. That allows you to demand full repayment anytime you want, even though you and the borrower may have informally agreed on a payment schedule. With a demand loan, the imputed gift amount is calculated year-by-year and is equal to the imputed interest for that year. As long as interest rates remain anywhere close to today’s rates, the annual imputed gift on a $100,000 loan will be well under the $11,000 annual limit for tax-free gifts. In contrast, when you make a below-market or interest-free term loan, the gift tax rules are much less favorable. Say you make a $100,000 interest-free loan calling for a balloon repayment after seven years. This is a term loan (as is a loan calling for installment principal payments). Essentially, you’re treated as making an immediate imputed gift to the borrower equal to seven years’ worth of imputed interest. On a $100,000 term loan, your imputed gift in the year the loan is made may well exceed the $11,000 annual exclusion. You’ll either owe current gift taxes or use up part of your lifetime exemption. Again, you can avoid both of these adverse outcomes simply by making a demand loan instead of a term loan. As long as you contractually retain demand rights on the loan, informal payment terms that are not otherwise legally enforceable should not affect the demand loan classification. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |