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March/April 2012
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March 1, 2011
Articles
Helping a Family Member in Need
Don’t let your intrafamily loan run afoul of the IRS
George’s son, Kevin, lost his job last year and is now having trouble paying his mortgage. George is happy to help his son by lending him six months’ worth of mortgage payments. However, George may not be so pleased if his intrafamily loan triggers gift and income tax liability.
Because of the difficult economic times of the past few years, this fictitious scenario — or one similar — is likely playing out in many households. If yours is among them, it’s important to understand how the IRS defines an intrafamily loan and know the rules surrounding such a loan.
A bona fide loan or a gift?
When lending money to family members, the first question to ask is: “Is this transaction truly a loan?” If the IRS concludes that the transaction isn’t a bona fide loan, it will recharacterize it as a taxable gift. By formalizing the transaction and treating it as a loan, you can avoid negative tax consequences and have the necessary documentation to support a bad-debt deduction in the event the borrower defaults.
The IRS and courts look at several factors in determining whether a transaction is a loan or a gift.
Although no one factor is controlling, an intrafamily loan is more likely to be viewed as bona fide if there’s a written agreement, interest is charged and there’s a fixed repayment schedule. In addition, the borrower must execute a promissory note and actually make the payments.
Not all of these factors must be present, but, the more that are there, the better your chances of the loan withstanding IRS scrutiny. Yet regardless of how much you plan, no strategy is bulletproof. The IRS still can recharacterize a loan as a gift if it determines that the loan’s purpose was to avoid taxes.
Is adequate interest being charged?
If an intrafamily transfer is a loan, the next question to consider is: “Are you charging adequate interest?” A loan is considered below market if you charge less than a minimum interest rate, which is determined by the applicable federal rate (AFR).
The federal government periodically sets the AFR, and the rate varies depending on the type and term of the loan.
For example, the minimum rate for a demand loan (one that’s payable on demand or has an indefinite maturity) is the short-term AFR, compounded semiannually. So, the minimum rate varies during the life of the loan. The easiest way to ensure that you charge enough interest for a demand loan is to use a variable rate that’s tied to the AFR.
For a loan with a set term, use the AFR that’s in effect on the loan date.
Type of loan affects tax impact
Below-market loans to family members have both income and gift tax consequences, and they differ depending on the loan type. For a demand loan, each tax year you’re treated as if 1) you’d made a taxable gift equal to the amount of imputed interest, and 2) the borrower transferred the money back to you as an interest payment. Imputed interest is the difference between the AFR and the amount of interest you actually collect, recalculated annually. Depending on the loan’s purpose, the borrower may be able to deduct this interest.
If interest is imputed to you, you’ll owe income taxes on the fictitious payments. In addition, you may have to pay gift taxes if the imputed interest exceeds the $13,000 annual gift tax exclusion. There are two important exceptions that allow you to avoid the imputed interest rules — or at least lessen their impact. First, loans up to $10,000 are generally exempt. Second, loans up to $100,000 are exempt if the borrower’s net investment income for the year is $1,000 or less. If net investment income exceeds $1,000, the imputed interest rules apply, but the amount of interest is limited to the amount of net investment income.
Term loans are treated essentially the same way as demand loans for income tax purposes. But the gift tax consequences are quite different. If you make a below-market term loan to a family member, your gift is equal to the excess of the loan amount over the present value of all future loan payments (using the AFR as the discount rate).
If you choose to make a low-interest or no-interest loan to a family member, try to avoid a term loan so you don’t make a substantial upfront gift.
A positive outcome
Whatever your reason for lending money to a family member, be sure you understand IRS rules governing intrafamily loans. Working with your estate planning advisor to ensure that your loan won’t incur income and gift tax liability will help result in a positive outcome for you and your loved one.
| Estate Planning Red Flag Crummey powers provide for withdrawal of a specific dollar amount |
A lifetime gifting plan that takes advantage of the $13,000 per recipient annual gift tax exclusion can be a powerful strategy for transferring wealth tax free. But the exclusion is available only for gifts of present interests. This can be a problem for contributions to trusts, which are generally considered gifts of future interests. Crummey powers give trust beneficiaries the right to withdraw contributions (up to the amount of the annual exclusion) for a specified period after they’re made (typically 30 days). Crummey powers, even if never exercised, convert a future interest into a present interest that qualifies for the annual exclusion (provided beneficiaries receive written notice of their rights). When drafting Crummey powers in a trust, avoid providing for withdrawal of a specific dollar amount, such as $13,000. Doing so can create two potential problems:
To avoid these problems, a trust should provide for withdrawal rights up to “the annual exclusion amount permitted by Internal Revenue Code Sec. 2503(b).” It should also provide language that will allow flexibility when needed to avoid negative tax consequences from the 5&5 rule.
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Contact one of our Estate Planning attorneys for more information:
 Barbara M. Kristiansson (651) 312-6041 bkristiansson@felhaber.com |
 Nicholas J. Kaster (651) 312-6037 nkaster@felhaber.com |
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Felhaber, Larson, Fenlon & Vogt, P.A. |
Felhaber, Larson, Fenlon & Vogt, P.A. |
www.felhaber.com |
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