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Be Sure to Follow Tax Rules When Lending Money
Dec 5, 2012
Lending money to family members not only helps them out financially, but can be a tax-effective way to transfer wealth to the next generation.
Lending rather than giving allows you to provide wealth to the younger generation without totally parting with the money. You can hold on to your retirement nest egg, while encouraging financial responsibility among your heirs.
When you lend money to family members, be sure to charge a rate of interest at least equal to the applicable federal rate (AFR). A lower interest rate can trigger adverse income and gift tax consequences.
The wealth transfer occurs when the younger generation invests the borrowed funds and earns a rate of return greater than the federal rate. When the borrower repays the loan plus interest, the borrower keeps the spread between the investment returns and the interest cost – without gift or estate taxes applying. Lower market rates of interest have kept the AFRs relatively low. So investment returns can outpace the interest rate on the loan.
Federal interest rates are published monthly and vary based on whether the term of the loan is short-term (three years or less), mid-term (more than three years but not more than nine years), or long-term (more than nine years). The AFR also varies depending on how frequently interest is compounded.
The loan balance itself is an asset in your estate. If you die before the loan is repaid, the borrower must still repay the loan to your estate, unless you structure the loan to have it forgiven if you die before it is paid off.
The downside of an intergenerational loan is the risk that the borrower’s investments will not outperform the AFR.
There is also a tax risk that the IRS might challenge the loan as a disguised gift. To avoid this result, you must treat the transaction as a legitimate loan.
Document the loan with a promissory note containing enforceable terms. If your heir is unable to make a payment, you should make a genuine effort to collect the funds.
In September 2012, a grandfather lends $1 million to his granddaughter for three years. The granddaughter signs a promissory note that requires annual payments of interest only at the AFR, at that time 0.21 percent. The loan calls for a balloon payment of principal at the end of the three-year term.
The granddaughter places the borrowed funds in investments that earn a 5 percent return. At the end of the loan term, the granddaughter’s investments will have grown to about $1,151,000, after using the investment income to make $2,100 of annual interest payments.
After repaying the $1 million principal, she is left with more than $150,000. Her grandfather has essentially transferred that amount to her, free of gift and estate taxes.
Shareholders or employees of a corporation often lend the business funds – expecting to be repaid.
If the loan does not get repaid, a bad debt deduction can be claimed. However, the tax treatment is different for ’business“ bad debts and ”nonbusiness“ bad debts.
A business bad debt results in an ordinary loss. A nonbusiness bad debt is treated as a short-term capital loss. For nonbusiness bad debts, a deduction is allowed only if the debt is wholly worthless. For a business bad debt, however, a loss is allowed for partial worthlessness.
If you lend money to a corporation that provides your primary means of employment, you may be able to show that the main purpose of the loan is to protect your trade or business as an employee. In that situation, business bad debt treatment should be available.
But if your primary motivation for the loan is an investment in the corporation, nonbusiness bad debt treatment is the result.
If you are both a shareholder in the corporation and an employee, the primary motive for making the loan may be difficult to prove.
This difficulty was highlighted in the recent Tax Court case Harry R. Haury v. Commissioner, TC Memo 2012-215, July 30, 2012.
Harry Haury was a software engineer who developed software and licensed it to NuParadigm Government Systems, Inc., and NPS Systems, Inc. Haury owned 48.3 percent of NuParadigm and 49.2 percent of NPS. He received compensation from NuParadigm but not from NPS.
To reduce cash-flow problems, Haury lent the companies almost $435,000 and claimed a business bad debt deduction when the loans were not repaid.
Although the court agreed that the loans were worthless, it concluded:
The dominant motivation for making the loans was not petitioner’s trade or business as an employee of the companies. … Petitioner designed the software used by the companies and invested a significant amount of time and money to ensure the success of the companies. Protection of petitioner’s investment interests in the companies, rather than protection of his salary, was the dominant motivation for the loans.
When lending money to any business in which you are involved, you should be sure to document both the terms of the loan and the reasons for making the loan.
PATH and PVS appreciate the hard work demonstrated by Steve Kelin and Wendy Roldan in completing the tax returns in a timely manner.
Patti Pearce | Associate Director of Finance