A Loan May Be Taxing, 12-31-2008
People lend money to their families all the time. Whether it is lending your daughter money to get settled after college or lending your son money to get started in business, it can be a great way to help your kids. However, it is important to know the rules of the road to avoid getting sideswiped by unexpected taxes.
If you charge interest, you must pay income tax on that interest. So, if you loan your son $200,000 at 5%, that $10,000 in interest must be added to your income for the year.
If you lend money, the IRS expects that you should charge interest, just like a bank would. It sets a benchmark rate, the “Applicable Federal Rate” (or “AFR”), which varies depending upon the month and the term of the loan. For example, in December 2008, the mid-term AFR was 2.85%. (The mid-term AFR is applicable to loans longer than two years and shorter than nine years in length.) If you charge less than this, or nothing, it is a “gift loan” and special rules apply.
A loan of less than $10,000 is disregarded. For a loan of between $10,000 and $100,000, if you charge interest less than the AFR, the difference is considered a gift for which you may have to pay a gift tax. If the loan is greater than $100,000, not only is the forgone interest considered a gift, but the IRS pretends that the forgone interest was paid to you as interest and you would have to pay income tax on it. Even though you are trying to be nice, you might get a big surprise come tax time!
For example, if you lend your son $200,000 in a 5-year (mid-term) interest-free loan to start a business in December 2008, the IRS will pretend your son paid you 2.85% of $200,000 = $5,700 and you must pay income tax on that amount annually. Assuming you are paying a combined 40% federal and state income tax rate, that would be $2,280 in tax each year.
There may be solutions to this. For example, an Irrevocable Trust that you set up for your son’s benefit could operate the business. The Trust could be set up so that transactions between you and your Trust are not considered for income tax purposes. So, if you lent the Trust $200,000, the IRS would ignore the forgone interest for income tax purposes. The forgone interest is still considered a gift. But, the Trust can be designed so that the “gift” to the Trust (of the forgone interest) will be considered a gift to your son. Since you can give $13,000 each year to anyone gift tax-free, this imaginary gift of $5,700 would be ignored.
Consult with a qualified estate planning attorney from Morris Hall to make sure your loans are structured so you do not generate unnecessary income taxation.