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Family Loans to Save Taxes Legal Tax Angles: How to Save Taxes Without Going to Jail The 1986 tax law introduced the basic rule that when someone (usually a parent) makes an interest free or low interest loan to a child, the parent will be treated as having received interest income equal to the federal interest rate on short term obligations. The child will be treated as having an interest expense and will be subject to the varied limitations on interest deductions. But if the child is in a zero tax bracket, it doesn't matter if there is no deduction allowed for the interest expense. The object of the 1986 law was to put the parent and child (or other related parties) in the same economic position they would have been in if the loan had not been made. In addition, the amount of forgone interest is treated as a gift from the parent to the child and uses up part of the annual gift tax exemption. There are two significant exceptions to these rules. First, if the loan is never more than $10,000 at any time during the year and if the money is not used to earn investment income, then the result is treated as a “de minimus” exception. To qualify, it would be necessary to show that the money is not used to purchase income producing investments. But, the loan could be used to purchase non-income producing (growth) investments. The second exception is where a gift loan is made between individuals for an amount of less than $100,000, the amount of the imputed interest to the parent (lender) is limited to the amount of the investment income earned by the child (borrower). And if the net investment income of the borrower is less than $1,000 in any year, then the net investment income is treated as if it were zero. Again, if the money is used to purchase assets that grow in value, such as raw land, collectibles or growth stocks, there is no investment income and there is no interest income imputed to the parent. However, there is a difficult “catch” to overcome with this exception. The exception is not available if “one of the purposes of the loan is tax avoidance”. Getting around that may require some creativity. In addition, if a child is under the age of 14, any investment income of the child in excess of $1,500 per year is taxed at the top rate of the parents. To simplify the tax preparation process, the parents can elect to have the child's investment income (in excess of $1,500) included in the return of the parent -- using tax form 8615. However, this rule does not apply to any earned income of a child of any age. And it does not apply to the investment income of a dependent child over the age of 13. Nor does it apply to loans to low income parents who might be in need of financial help for a long term care facility. For dependent children under the age of 14, the first $750 of investment income is subject to a zero tax rate. The next $750 of investment income is subject to a tax rate of 10%. With the low yields available on many investments in early 2003, a child would need about $50,000 to earn $1,500 a year of safe investment income. If that were interest income, the parent would have been paying as much as 35% for federal taxes, plus state income taxes. The savings in federal taxes alone could be $450 per year for each child under the age of 14. If the child is over the age of 13, there are greater opportunities for tax savings. If the child can invest the money at a rate significantly greater than the short term federal rate, there is still an advantage in making such loans. For example, if the short term federal rate is 3% and the child can invest the money in tax lien certificates at 12%, there is a net spread of 9%. With a loan of $100,000, the child is making $9,000 a year, subject to tax at a 10% rate. (After the personal exemption and standard deduction, the child would be in the 10% tax bracket.) However, the parent loses the personal exemption of $3,050 (for 2003) which is worth up to $1,067 in federal taxes (at a 35% rate). Thus, the loan arrangement is worth a tax savings of nearly $3,950 a year -- based on this example. A variation of the interest free loan in reverse is to make an irrevocable gift of some money to a child or grandchild and to later borrow the money back - at the highest prevailing interest rate. If the use of the borrowed funds is for a deductible purpose (such as for a business loan), the interest should be deductible. There is a potential problem with the legal capacity of a minor child to enter into loan transactions, so it would be necessary for the other parent to act on behalf of the child - or perhaps for a grandparent to act for the child. That can be done with a simple revocable trust in which the other parent (or grandparent) is the trustee. Or this tactic can be limited to cases involving children who are of legal age. Vern Jacobs Copyright, 2003 |
Books and Services by Vern Jacobs
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