Welcome to the year-end holiday giving season. Sometimes, that involves money. Let’s say you made a sizable loan to your daughter so she could purchase a residence. While you expect to be repaid, there is no specific time for repayment and the loan carries no interest. How does this work? For answers, we turn to Bruce Bell, who is an attorney at the Chicago office of Schoenberg, Finkel, Newman & Rosenberg.
Larry Light: You want to be nice and helpful to your loved one. But what are the tax consequences of this arrangement?
Bruce Bell: Persons who make non-interest-bearing loans face various tax consequences. The borrower is treated as having made interest payments to the lender, computed based on IRS-prescribed interest rates in effect from time to time, known as the Applicable Federal Rate. These consequences concern loans between family members, an employer and an employee and a corporation and a shareholder.
Light: So this imputed interest rate, which I understand is around 2%, is phantom money, but the tax man treats it likes it’s real?
Bell: Yes, with a parent-child loan, the imputed represents taxable income to the parent. Even though the parent will not receive any interest payments, the parent must nevertheless report the imputed income each year as taxable income on the parent’s personal income tax returns and pay tax on this amount.
Light: How is this money treated, exactly?
Bell: Like a taxable gift from the parent to the child. That means the parent has to file a gift tax return if the imputed interest exceeds the annual gift tax exclusion, which is $15,000 per donor. That can be doubled if a husband and wife each make such a gift, to $30,000 yearly.
Light: Odds are you as the parent won’t have to pay a dime in gift tax, even if the loan amount—also known as a gift, for tax purposes—exceeds $15,000, or $30,000 if from a married couple. The amount is excluded from your lifetime gift tax exemption, which now is $11.4 million. Above that, people pay rates ranging from 18% to 40%. If you’re in that league, what can you do?
Bell: If gift tax consequences are a concern, have your child start paying interest to you each year until the loan is fully repaid. That can be a cash crunch for your child. So increase the loan amount to provide additional cash to your child to cover the interest payments. While the interest will still be subject to income tax, you can at least avoid the gift tax filing and any unintended use of your estate and gift tax exemption.
Light: What about giving to people who aren’t your relatives? For instance, an employee?
Bell: The rules are similar. But here, the imputed interest is treated as taxable compensation to the employee. That means payroll taxes will also be imposed.
Light: How should donors handle the paperwork for such loans?
Bell: Appropriate documentation should be in place to establish the principal repayment obligation. Create a promissory note or similar document setting up your child’s obligation to repay the loan to you.
If there is no specific repayment date, the promissory note can provide for payment to be made upon demand by you as lender. Hence, the debt will become due and required to be repaid when you choose. This way, you gain the flexibility of not being tied to a specific repayment schedule.
Light: What if you don’t bother with the documentation?
Bell: Then the IRS might claim that the full amount of the loan you made was a gift at the time the loan was made. Also, if your child refuses to repay the loan to you or your child dies before you, you can at least show you have a formal arrangement in place, and the transferred money was indeed a loan. That avoids complications.