As pointed out in my last blog dealing with Family Loans: A Possible Estate Planning Tool in Certain Situations, it can often be a fine line between a bona fide loan transaction and a gift for tax purposes. The IRS looks at multiple factors when it is examining such a situation. At the end of the day, as the saying goes, it is a “facts and circumstances” test.
This blog will point out several of the key factors to structure a transaction as a loan.
The parent should not go to the expense of structuring a loan transaction if there is a pre-conceived plan in place that the parent never intends for the child to repay the obligation. The advice would be to just treat it as a gift. Having a well-documented transaction doesn’t carry much weight where the parent forgives each annual payment of principal and interest. On the other hand, there is nothing wrong with the parent forgiving required payments of principal and interest periodically.
A parent should really not expect a loan transaction to hold up under IRS scrutiny if the child is unemployed and/or has no prospects of ever repaying the “loan.” There needs to be some prospect of repayment. No one loans money knowing that the debt obligation cannot be repaid.
While both demand notes and installment notes can be utilized for evidencing the debt, a term note that calls for regular payments (where payments are in fact made) likely will be more persuasive than a demand note where payments are not made.
Memorialize payments as made. With the wealth of software available today, this should not be a difficult task. And it would offer a bit of evidence that the parent is really treating the transaction as an arm’s-length loan.
Obtain security for the repayment of the loan where such would be required in a normal arms-length loan transaction. If the parents are lending a child money to purchase a house, a promissory note signed by the child (and spouse) evidencing the loan should be secured by a deed of trust in favor of the parents.
There are occasions where a loan transaction is appropriate in advancing funds from parents to children for financial, tax and/or personal reasons. A properly documented and enforced transaction, however, is essential in seeking to have the transaction treated as a bona-fide loan rather than as a gift.
Michael W. Margrave
Disclaimer: This blog is for information purposes only. Legal advice is provided only through a formal, written attorney/client agreement.