The simplest way to provide financial assistance to a child or another family member is to get out your checkbook, confirm the balance and make a gift of an amount up to the annual exclusion amount of $14,000 (in 2016). However, if the gift that you have in mind is more than $14,000, and you are concerned about gift taxes and the requirement of filing a U.S. Gift Tax Return, a loan may be preferable. Intra-family loans must be structured and managed carefully to ensure that the IRS will treat them as bona fide loans rather than disguised gifts.

Factors to determine loan legitimacy

Here are some factors the IRS considers when determining if a loan between related parties is legitimate:

•        Existence of a promissory note or another instrument evidencing the indebtedness,

•        Payment of a reasonable rate of interest,

•        A fixed repayment schedule,

•        Adequate collateral or other security,

•        Actual repayment of the loan,

•        Whether, at the time the loan was made, the borrower had a reasonable prospect of repaying the loan and the lender had sufficient funds to make the loan, and

•        The conduct of the parties.

The last factor is a catch-all that encompasses one of the distinguishing characteristics of a bona fide loan: the parties’ intention that the money advanced will be repaid. An examination of the first six factors may reveal conduct that’s inconsistent with a loan, such as failure to execute a promissory note or to repay the loan. But other conduct may also indicate the lack of a debtor-creditor relationship, such as executing a promissory note after the fact or the lender’s failure to make reasonable collection efforts.

Proper documentation required

If you treat the transaction like a “real” loan, it’s more likely that the IRS will treat it as a loan as well.

If you are interested in reading more about this planning technique, an interesting article appears here.

If you decide to make a loan to a loved one, we can help ensure it’s properly documented to pass IRS muster.