Interest rates have been at historical lows for several years. This situation may have prompted you to loan money to family members and other related parties at favorable rates, without fear of tax repercussions. However, now that rates are on the rise, you may need to reevaluate related-party loans to ensure they won't trigger any federal income or gift tax issues.
Related-party loans can happen in a variety of scenarios. For instance, a parent might loan an adult child funds to launch a new business or make a down payment on a house. While the parent usually doesn't regard the transaction as an investment, both parties can benefit financially. The parent benefits by earning interest at a rate higher than available on a certificate of deposit or similar investment vehicle. Likewise, the adult child benefits by paying a lower rate than what's available from a commercial lender.
Related-party loans also can arise in the context of a closely held business. For instance, a business could loan money to a shareholder at a low or zero rate — and vice versa.
The advantages of related-party loans usually are clear. But you might not realize that your choice of interest rate could result in taxable income for the lender and a taxable gift, dividend, capital contribution or taxable compensation for the borrower.
In large part, the tax treatment of related-party loans turns on the applicable federal rate (AFR). The AFR is the minimum interest rate that the IRS allows for private loans. Published by the IRS monthly, the AFR reflects current market conditions and often is lower than commercial loan rates.
If a related-party loan carries an interest rate at or above the AFR, you typically don't need to worry about tax issues. When the rate falls below the AFR, you may be subject to the imputed interest rules.
The term "imputed interest" refers to interest that the tax code assumes a lender earned based on the AFR, even though the lender didn't actually collect that amount. The "foregone interest" — the interest the borrower would have paid under the AFR less the stated interest — is imputed to both the borrower and the lender. The lender generally must recognize it as interest income, while the borrower may be able to deduct it as interest expense.
To illustrate, let's say you lent your child $100,000 at 0.1% interest ($100) while the AFR was 2% ($2,000). The foregone interest would be $1,900 ($2,000 minus $100). In the view of the IRS, you transferred the foregone interest to your child, and your child transferred that amount back to you. The timing and nature of these deemed transfers depend on several factors, such as the type and term of the loan, the relationship between the parties and the reason for the loan.
For example, the foregone interest on a so-called "demand" loan (payable in full anytime on the lender's demand) is deemed to transfer in both directions on December 31 of each year the loan is outstanding.
Conversely, for term loans, the foregone interest is generally treated as transferred from the lender to the borrower on the day the loan is made. The transfer back to the lender occurs over the term of the loan. Additional rules apply for gift loans, where the foregone interest is in the nature of a gift, and loans between corporations and shareholders.
You might avoid (or at least reduce) the effects of the imputed interest rules if your arrangement falls within one of the exceptions. For example, the rules generally don't apply to gift loans of $10,000 or less between individuals as long as the loan is a demand loan. This de minimis exception doesn't apply if the loan funds are used to acquire or carry assets that generate ordinary income.
The IRS also recognizes a "de minimis" exception for loans between a corporation and its shareholders. The imputed interest rules generally don't apply if the aggregate outstanding amount of loans between the corporation and the shareholder is $10,000 or less.
Gift loans between individuals of $100,000 or less fall into the net investment income exception. For every day during the borrower's tax year that the total principal amount of loans from the lender falls under that threshold, the interest that's deemed transferred from the borrower to the lender is limited to the borrower's net investment income. If that amount is less than $1,000, the borrower is considered to have no investment income.
In addition, the tax code exempts loans where the interest arrangements don't have a significant effect on the federal tax liability of the lender or borrower. For example, certain loans to help an employee relocate aren't subject to the imputed interest rules.
As interest rates begin to climb, you might want to restructure any related-party loans to avoid the imputed interest rules. Bear in mind, though, that loans structured primarily to avoid federal taxes for either the lender or the borrower may not qualify for an exception. Contact your tax advisor to help you minimize the tax impact for both parties and answer any additional questions you might have about related-party loans.
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