Question: I loaned a sizeable sum to my daughter to enable her to purchase a residence. While I expect to be repaid, there is no specific time for repayment and no interest will be paid on the loan. What are the tax consequences of this arrangement?
Answer: Persons who make non-interest bearing loans face various tax consequences. The borrower of a non-interest bearing loan is treated as having made interest payments to the lender computed based on IRS-prescribed interest rates in effect from time to time, the Applicable Federal Rate. The lender, in turn, is treated as having retransferred the imputed interest to the borrower. These consequences arise in a variety of situations including loans between family members, an employer and an employee, and a corporation and a shareholder.
With a parent/child loan, the imputed interest the child is deemed to have repaid to the parent represents taxable income to the parent. Even though the parent will not receive any interest payments, the parent must nevertheless report the imputed income each year as taxable income on the parent’s personal income tax returns and pay tax on this amount. The amount of imputed interest the parent is deemed to have retransferred to the child will be treated as a taxable gift from the parent to the child. If the amount of this gift, together with any other gifts the parent has made to the child for the tax year in question, exceeds the annual gift tax exclusion, the excess may use some portion of the parent’s lifetime exemption for estate and gift tax purposes. Although no gift tax may have to be paid, a gift tax return is required to be filed if the imputed interest exceeds the annual gift tax exclusion.
The current annual gift tax exclusion is $15,000 per year, per donee, or $30,000 per year if a husband and a wife elect to split gifts between them. In the later case, the amount of the donor’s lifetime exemption for estate and gift tax that is utilized may be reduced if the donor is married and the couple chooses to split the gift between the two of them. A gift tax return must be filed if a married couple elects to split gifts made for a calendar year.
If gift tax consequences are a concern, you might have your child pay interest to you each year until the loan is fully repaid. To mitigate the cash flow concerns your child may face, you can increase the amount advanced to provide additional cash to your child to cover the interest payments. While the interest will still be subject to income tax, you can at least avoid the gift tax filing and any unintended use of your estate and gift tax exemption.
Similar income tax issues arise in other contexts such as an interest-free loan from an employer to an employee. In such case, the imputed interest is treated as having been transferred from the employee to the employer which will be taxable as interest income to the employer. The imputed interest will then be deemed to have been retransferred by the employer to the employee which will be treated as taxable compensation to the employee. Due to the compensatory nature of the deemed transfer from the employer to the employee, payroll taxes will also be imposed.
Regardless of your intention, appropriate documentation should be in place to establish the principal repayment obligation. A promissory note or similar document should be created evidencing your child’s obligation to repay the loan to you. If there is no specific repayment date, the promissory note can provide for payment to be made upon demand by you as lender meaning the debt will become due and required to be repaid when you choose, thereby providing the flexibility of not being tied to a specific repayment schedule. Absent this documentation, the IRS might claim that the full amount of the loan you made was a gift at the time the loan was made. Having appropriate documentation in place may be helpful from a non-tax perspective as well. In the unfortunate circumstance that your child refuses to repay the loan to you or in the event your child predeceases you, complications that might otherwise arise in enforcing the repayment obligation can perhaps be avoided.
The Tax Corner addresses various tax, estate, asset protection and other business matters. Should you have any questions regarding the subject matter or if you have questions you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to firstname.lastname@example.org.