Update 2014-03-08: Estate Planning Issues With Intra-Family Loans and Notes by Steve R. Akers, Bessemer Trust, August 2012 has examples, advantages/disadvantages of loans vs gifts, and applicable legal precedent.
Quote from the article regarding problems with loans
The article continues with relevant cases and revenue rulings (specifically Revenue Ruling 77-299). The conclusion of the cases/revenue ruling section points out several good items to consider.
Properly documenting, structuring, and administering a loan is important to avoid treatment as a gift. This includes:
- A signed promissory note with a fixed repayment schedule with an interest rate at or above the AFR
- Secure or collateralize the debt
- Demand repayment
- Maintain records
Problem with loans that are payable on demand: Dickman v. Commissioner held that interest-free loans between family members are gifts for federal gift tax purposes.
This is a great article that goes on to cover many additional issues and scenarios.
Overview article from Smart Money (last updated 12-13-2007) Loans Among Family Members. Although an interesting summary, the article doesn't mention the applicable Internal Revenue Code - so follow-up to specifics is impossible without more research.
IRC section 7872 contains the additional information needed to examine the issues and exceptions of loans to family members.
- CPA Journal, 1998, TAX COURT RULES ZERO INTEREST LOANS ARE TAXABLE INTEREST INCOME
- CPA Journal, 2006, Interest-Free Loans to Shareholders - An Opportunity to Reduce Overall Tax Costs
- Sec. 7872. Treatment of loans with below-market interest rates (as of January 3, 2006) -- see the summary of the most important provisions below.
- IRS Code section 163(d)(4) - Net Investment Income -- text is this section is at the bottom of the page
Applicable Federal Rates:
Other possibly relevant documents
- Family Budget Spreadsheet - use a zero based approach to determine how income covers necessities first and then trickles down and stops at optional spending.
- IRS Pub 550 - pg 6 & 7
- see also Ch 3 for calculation notes on Net Investment Income, pg 32 -
- Net investment income generally includes interest, dividends, annuities, and royalties. It does NOT include qualified dividends or net capital gain.
- Form 4952, Investment Interest Expense Deduction for calculating Net Investment Income
TITLE 26--INTERNAL REVENUE CODE Subtitle F--Procedure and Administration CHAPTER 80--GENERAL RULES Subchapter C--Provisions Affecting More Than One Subtitle
Sec. 7872. Treatment of loans with below-market interest rates
(a) Treatment of gift loans and demand loans
(1) In general For purposes of this title, in the case of any below-market loan to which this section applies and which is a gift loan or a demand loan, the forgone interest shall be treated as-- (A) transferred from the lender to the borrower, and (B) retransferred by the borrower to the lender as interest. (2) Time when transfers made Except as otherwise provided in regulations prescribed by the Secretary, any forgone interest attributable to periods during any calendar year shall be treated as transferred (and retransferred) under paragraph (1) on the last day of such calendar year.
(c) Below-market loans to which section applies
(2) $10,000 de minimis exception for gift loans between individuals (A) In general In the case of any gift loan directly between individuals, this section shall not apply to any day on which the aggregate outstanding amount of loans between such individuals does not exceed $10,000.
(d) Special rules for gift loans
(1) Limitation on interest accrual for purposes of income taxes where loans do not exceed $100,000 (A) In general For purposes of subtitle A, in the case of a gift loan directly between individuals, the amount treated as retransferred by the borrower to the lender as of the close of any year shall not exceed the borrower's net investment income for such year.
(E) Net investment income For purposes of this paragraph-- (i) In general The term net investment income has the meaning given such term by section 163(d)(4). (ii) De minimis rule If the net investment income of any borrower for any year does not exceed $1,000, the net investment income of such borrower for such year shall be treated as zero.
(f) Other definitions and special rules
(2) Applicable Federal rate
(B) Demand loans In the case of a demand loan, the applicable Federal rate shall be the Federal short-term rate in effect under section 1274(d) for the period for which the amount of forgone interest is being determined, compounded semiannually. (3) Gift loan The term ``gift loan'' means any below-market loan where the forgoing of interest is in the nature of a gift. (4) Amount loaned The term ``amount loaned'' means the amount received by the borrower. (5) Demand loan The term ``demand loan'' means any loan which is payable in full at any time on the demand of the lender. Such term also includes (for purposes other than determining the applicable Federal rate under paragraph (2)) any loan if the benefits of the interest arrangements of such loan are not transferable and are conditioned on the future performance of substantial services by an individual. To the extent provided in regulations, such term also includes any loan with an indefinite maturity.
TITLE 26--INTERNAL REVENUE CODE Subtitle A--Income Taxes CHAPTER 1--NORMAL TAXES AND SURTAXES Subchapter B--Computation of Taxable Income PART VI--ITEMIZED DEDUCTIONS FOR INDIVIDUALS AND CORPORATIONS
Sec. 163. Interest
(4) Net investment income For purposes of this subsection-- (A) In general The term ``net investment income'' means the excess of-- (i) investment income, over (ii) investment expenses. (B) Investment income The term ``investment income'' means the sum of-- (i) gross income from property held for investment (other than any gain taken into account under clause (ii)(I)), (ii) the excess (if any) of-- (I) the net gain attributable to the disposition of property held for investment, over (II) the net capital gain determined by only taking into account gains and losses from dispositions of property held for investment, plus (iii) so much of the net capital gain referred to in clause (ii)(II) (or, if lesser, the net gain referred to in clause (ii)(I)) as the taxpayer elects to take into account under this clause. Such term shall include qualified dividend income (as defined in section 1(h)(11)(B)) only to the extent the taxpayer elects to treat such income as investment income for purposes of this subsection. (C) Investment expenses The term ``investment expenses'' means the deductions allowed under this chapter (other than for interest) which are directly connected with the production of investment income. (D) Income and expenses from passive activities Investment income and investment expenses shall not include any income or expenses taken into account under section 469 in computing income or loss from a passive activity. (E) Reduction in investment income during phase-in of passive loss rules Investment income of the taxpayer for any taxable year shall be reduced by the amount of the passive activity loss to which section 469(a) does not apply for such taxable year by reason of section 469(m). The preceding sentence shall not apply to any portion of such passive activity loss which is attributable to a rental real estate activity with respect to which the taxpayer actively participates (within the meaning of section 469(i)(6)) during such taxable year.
David McCullough interview in Belmont Vision