The following article was published on 10/16/11 by the Capital-Gazette Newspapers (the Sunday Capital Newspaper Edition). This is one of a series of monthly columns authored by Tom Stemmy that will appear periodically on this website. 


     When giving cash to friends and family caution is advised                   


    The odds are good that most of us will one day be approached by a close friend or relative in need of a cash fix. But, if you’re thinking about doling out money to anyone, you need to first decide if it would be better for you to (a) make an outright gift or (b) make a loan with the expectation of repayment.  Be aware that your decision just might have significant tax implications in these changing times that should be well understood.  

    First, a look at an outright gift - Let’s say one of your adult children is in a tight spot and comes to you for a cash advance.  Everyone is aware that small cash gifts generally don’t have to be reported to IRS.  However, you should also keep in mind that if you give Junior more than $13,000 in a single year it still needs to be reported on a gift tax return, and this could have an effect on your general estate situation.    

     But, some might wonder, “Why would anyone bother reporting a gift when their estate will likely not be taxed under the friendly new estate tax rules?”  It is true, under the 2010 Tax Act, the government has deigned to provide everybody a $5,000,000 lifetime exemption for estate and gift transfers. However, no one said that you no longer have to report gifts to individuals when they exceed $13,000 in one year.  

    Here’s the key. The generous $5,000,000 lifetime exemption is only on the books until 12/31/12.  Ask your adviser about the dreaded “claw back” rule that many experts fear will prevail after 2012 in this sputtering economy.  This means that ALL of the reportable gifts that you made during your lifetime could be “clawed back” into your estate after 2012 - regardless of how much exemption Congress will allow after next year.  Hence, you shouldn’t assume that IRS will not monitor your gift transfers in the months ahead even though you don’t have any tax liability right now.

      What about the loan option?  You need to look at the big picture before deciding if it would be advantageous to treat your cash advance to Junior as a loan rather than an outright gift.  For one thing, a properly documented loan will show the IRS that you had not intended to make a reportable gift.  At the same time, it will set the record straight with Junior about loan terms and your expectation of repayment.  Additionally, certain tax reporting issues can be easily eliminated with a bit of documentation.  

     Remember, IRS can be sensitive about the legitimacy of loans – especially when they’re between family members.  Thus, your loan document should make it clear that you are making an arm’s-length loan (not a gift) and you expect to be repaid.  It always helps to spell out the payment terms and any interest to be charged.  And, if possible, try and secure collateral.    

    What about interest charges on the loan?  – All too often, good-intentioned lenders will try to keep things simple by making an interest-free loan, especially within the family. This may not be a good idea. IRS is well aware that, with true bona-fide loans, a reasonable interest rate is usually charged and paid by the borrower. In fact, if you make an “interest-free” loan over $10,000 to anyone, the IRS will help you fill in the blanks. It will “impute” the interest for you - based on rates set by the Treasury.  As a result, you will wind up paying tax on fictitious interest that you never received.  Recommendation: Set a minimal (but reasonable) interest rate with all loans that you make.   


     What happens if your loan doesn’t get repaid?  By now, you’ve probably guessed that if you were to lend say $20,000 or $30,000 to a friend or a relative, you might need a team of tax pros just to prove you have a bona-fide debt. Well, guess what? If that loan becomes uncollectible, you might wish you had a folder full of records.  That is because you could be eligible for an attractive (bad-debt) tax deduction in the year of worthlessness.  At the same time you may now be asking, “Is it really worth all the paperwork?”

     Hold on, here’s some good news.  In a landmark tax court decision, it was observed that a valid debt may exist without all the legal formalities - even between related parties.  When a taxpayer loaned his daughter more than $36,000 to start up her own business, he didn’t follow all the recommended legal steps - like executing a note, setting payment terms, securing collateral, etc. However, by inference, he was able to show that an agreement did indeed exist with his daughter and that she would attempt to repay the loan when the business became successful.

    In short, the taxpayer prevailed over the IRS because his intentions were proved with business-like actions and by making informal notations – such as marking “loan” on checks and deposit slips, etc.  Most important, he and his daughter were recognized as creditable witnesses with a prior debtor-creditor relationship.        

    Final Tip: Although you might be able to prove by alternate means your intention to make a valid loan, you could save yourself much cost and aggravation by having a few loan documents properly drafted in the first place.       


Thomas. J. Stemmy, CPA, CVA, EA, of Annapolis is an award-winning author and partner with Stemmy, Tidler & Morris in Greenbelt. He is the author of “Top Tax Saving Ideas for Today’s Small Business.”  

























































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