Entrepreneurs in Miami and elsewhere are familiar with making and receiving loans as commonplace tools in the management of their businesses. One need look no further than the growth of Miami’s skyline through debt-financed development to understand how other people’s money can be leveraged to create new wealth for investors.
Managing Intra-Family Loans
It is natural, then, that entrepreneurs are generous in making loans to family members (especially children) to help them get a start in life or build businesses of their own. Such loans, if properly formulated, documented, secured, and managed, can have the additional benefit of effecting an estate-tax and income tax free transfer of wealth to a younger generation. Many of these loans are made to “grantor trusts” to achieve the maximum income tax benefits.
However, it is not uncommon for entrepreneurs to be overly generous with the terms and management of intra-family loans. Loans that do not carry sufficient interest, or have sufficient security, or the terms of which are not actually enforced, may be recharacterized by the IRS as taxable gifts. Such gifts will (after application of the “annual exclusion”) count against the lifetime gift tax “applicable exclusion amount” and, if the exclusion amount is exceeded, subject the lender to gift tax in the amount of 40% of the value of the loan/gift. The IRS may also argue that unpaid interest is taxable in the year accrued, if no real effort is made at collection.
Structuring the Loan Transaction
So what steps should the lender take to ensure that the loan is treated as such by the IRS? The following are all recommended measures that should be taken in order to help strengthen the lender’s position that the transferred funds were in fact a loan and not a gift:
- The loan should be documented by a promissory note.
- The promissory note should contain a fixed repayment schedule and a clear maturity date.
- The loan should charge an adequate rate of interest (a safe harbor rate known as the “applicable federal rate,” which is quite low by commercial standards, is published monthly by the IRS).
- The loan should actually be repaid by its terms.
- The loan should be adequately secured.
- The loan may be made to a “grantor trust,” which makes repayment of loan interest income tax free.
With these few simple steps, generous family members may help the younger generation while protecting themselves from undue IRS scrutiny and unexpected taxation.