Charging Interest

Because you don’t want the loan to be too burdensome to the parents-to-be, you consider requiring them to pay only nominal interest — or even no interest — on the debt. Unfortunately, you need to think twice about such kindness because it can result in a taxable gift for you and taxable income for your son in the amount of the foregone interest. To avoid this result, require interest payments at a rate at least equal to the applicable federal rate as of the date of the loan.

Forgiving the Debt

After a couple of years, your son quits his job to stay at home full-time with the kids. As a result of the drop in income, he is unable to continue making payments, and you decide to forgive the debt. This leads to several complications.

By forgiving the debt, you will make a gift of the outstanding principal indebtedness. Because the gift exceeds the annual $10,000 ($20,000 for a married donor whose spouse consents to gift-splitting) per donee gift tax exclusion, you will have to use a portion of your unified credit to shelter the gift from a current transfer tax.

One way to avoid using any of your unified credit is to forgive the loan balance over a period of years and take maximum advantage of the annual gift tax exclusion. The Internal Revenue Service (IRS), however, may claim a pre-arranged plan and thus argue that the loan was actually all forgiven at once. You can minimize this argument if your son pays at least the interest on the loan.

Lending to Someone Who Is Insolvent

What if your son was insolvent at the time you made the loan? The familial relationship can be a problem. If you knew there was no way he could repay you, the IRS could probably successfully argue that you made a taxable gift from the start. If the possibility of repayment existed initially, but later your son became insolvent, your relationship may give rise to a taxable gift at the time of insolvency.

Dying Before the Loan Is Paid

If you die before your son has paid off the loan, a situation could arise where he is indebted to his siblings. While we all like to think that our children will always get along, adding money to the picture often has disastrous consequences. Proper planning can avoid the intra-family issues.

One alternative is to forgive the loan on death. A simple statement in your will or trust may be all that is necessary, although again, this act of kindness may result in problems. First, acknowledging the indebtedness results in an acknowledgment of the asset, which in turn raises valuation issues. Second, by essentially letting one child off the hook, other children may feel slighted. Consider equalization with those other children, including accounting for use of funds by the borrower and accrued interest on the indebtedness, to ensure a true equalization. Good record keeping is essential. While equalization may seem unduly complicated, knowing your children will help you decide your course of action.

Structuring Loans Properly Is Essential