Many of my California clients make interest-free or low-interest loans to their children as part of a business transaction between them. Many business clients either forego interest altogether or miss collecting all the interest. In either case, foregone interest or missed payments must be imputed on loans between family members at the AFR (applicable federal rate).
Consider, for instance, that in January 2007 you loaned $500,000 to your child which was payable in 9 years. Also assume you are not charging interest. Loans three to nine years are considered mid-term loans. In January 2007, the AFR that the IRS publishes was 5.51%. The imputed interest is $27,550 each year which must be recognized on your income tax return. If your child doesn’t pay the interest, then you are deemed to have made a gift to your child. Your child does not get a tax deduction for the $27,550 since no payments were actually made.
Some of the tax consequences can be avoided if you qualify for either of two exceptions:
First, if the amount of below-market loans you make to a child doesn’t exceed $10,000, no interest will be imputed. To get this tax break, the loan can’t be used for income-producing investments.
Second, if the amount of below-market loans you make to a child doesn’t exceed $100,000, no income tax consequences will apply. That will be the case if the child’s net investment income is no more than $1,000 each year.
Try to keep loans below those levels, see that the other requirements are met, and put all intra-family loans in writing to minimize tax problems.
If you have to write a business contract, negotiate a business transaction, want to form a new entity, or have other questions related to your business you would like to discuss with an attorney, call Mitchell A. Port at (310) 559-5259.