Loans to Relatives Have Their Rules
QUESTION--My husband and I want to lend our son and daughter-in-law money for a year. But we read that a certain interest rate must be charged in lending money to relatives. Do you know what that amount is and whether it varies depending on the length and purpose of the loan?--B.H.L.
ANSWER--Until this year, you could charge whatever you pleased--or nothing, for that matter. But because hundreds of thousands of taxpayers were making such loans purely as a means to dodge taxes, the Tax Reform Act of 1984 clamped some very strict rules on such loans.
The rules are weighty and complex. But the gist is this: If your loan is for less than $10,000, you can charge any rate that is mutually acceptable to you and your son and his wife. For loans exceeding $10,000, however, the borrower or lender or both face an additional tax liability if the interest rate is less than the rate prescribed by the IRS. The purpose of your loan isn’t a factor.
On a short-term loan such as the one you propose, the minimum annual interest rate is 12.37% for loans granted between Jan. 1 and June 30 of this year. Should you decide to lend the money for three to nine years, you must charge at least 13.37%. And the current minimum rate for long-term loans is 13.43%.
These rates will be redetermined every six months. They are based on the average market yield on outstanding U.S. debt obligations with comparable maturities.
What happens if you decide to flout the rules because your son and daughter-in-law either can’t afford such a high level of interest or shouldn’t have to pay it? The IRS will see to it that you or your son make up the difference in additional income taxes.
Your loan would be regarded as a below-market or interest-free loan and you would be presumed to have charged your son the prescribed rate of interest. In other words, you would be deemed to have received a certain amount of interest income from your son for the loan, and you would be taxed accordingly.
There also are cases in which such loans would trigger the payment of gift taxes. (I warned you that this got complicated.)
Moreover, there is an entirely different set of rules for below-market rates on the sale of property, another income-reducing technique often used by parents and their children. But the IRS took so much heat from special-interest groups when these rules were proposed that their implementation has been postponed to July, 1985.
Why does lending money to relatives, friends or employees at a low interest rate constitute abuse? Because the bulk of such loans are motivated by a desire to avoid taxes or to disguise dividends and taxable compensation, says former IRS spokeswoman Laura B. Myers, who is now a partner in the tax consulting firm of Ellison & Myers in Huntington Beach.
Here’s how it has worked in the past: A father would lend his daughter $10,000, say, at a nominal rate of interest or no interest at all, and invest it. The income from that investment would then be reported by the daughter rather than by the father. Since the child is likely to be in a much lower tax bracket than the parent, she would pay less tax, or no tax at all.
The new rules apply to term loans made after June 7, 1984, and to amounts outstanding on demand loans after that date. Demand loans that were outstanding before last June 7 will be exempt from the new rules if they are repaid by March 1.
Q.--What are the tax considerations in regard to money accumulated in an Individual Retirement Account (IRA) following the death of the retiree? Does the money go into the decedent’s estate and become subject to inheritance tax? Or is it considered separate from the estate and treated as ordinary income on which the beneficiary will be taxed? Lastly, can the beneficiary merely add the IRA money to his own IRA account and pay the tax when he actually withdraws it?--S.S.H.
A.--Regardless of the relationship between the deceased and the beneficiary, the money in the IRA does not have to be included in the estate for inheritance tax purposes. But the money must be distributed within five years of the death and taxed as ordinary income to the beneficiary.
If the beneficiary is the spouse of the deceased, he or she may elect to roll over the IRA distribution to another IRA or other qualified retirement plan. In that case, the income taxes would not be due until the beneficiary withdraws the money for retirement.
Q.--My wife and I are the sole owners of a small manufacturing business with nine employees and a high turnover rate. We would like to accumulate some retirement funds in a plan for self-employed persons, known as a Keogh. But my banker says we cannot do this unless we cover all of the employees in our little business as well as ourselves. We hesitate putting them all on a Keogh because of the paper work involved. Is the banker right? Also, can I start a Keogh if I already have an IRA?--C.W.H.
A.--The answer is yes to both of your questions.
The tax laws require self-employed persons covered by a Keogh to also cover their employees. But you do have some choices.
If the paper work stemming from high turnover is your chief concern, for example, you could elect to make the start of coverage conditional upon three years of service. In exchange, however, employees who stay for three years or longer would have the unforfeitable right to their Keogh money. (If they quit shortly thereafter, say, they would be entitled to their Keogh funds; whereas participants in many retirement funds have to meet minimum balance and minimum participation requirements before they are entitled to take out their money.)
If that seems like too high a price to pay, you must instead cover any employee who has been with the company one year or longer or who reaches the age of 21, whichever occurs later.
On a brighter note, any contributions you make on behalf of an employee is a deductible business expense.
Debra Whitefield cannot answer mail individually but will respond in this column to financial questions of general interest. Do not telephone. Write to Money Talk, Business Section, The Times, Times Mirror Square, Los Angeles 90053.
