Benefits of Family Loans
Loans between family members are common transactions for many reasons. Each party to the loan (the borrower and the lender) usually knows the other well and feels confident that the other side will honor the deal. The lender may feel that the loan is both low-risk and a benefit to a loved one. The borrower may have access to more funds more quickly and at lower interest rates than a bank would offer. If there are issues with repayment, there may be more opportunity to renegotiate the deal and avoid default. For each side, any interest on the loan stays within the family rather than going to a third party such as a bank.
Risks of Family Loans
Like all loans, intrafamily loans have risks. Some risks are unique to family loans. In the event of a default or dispute, there is more than money on the line: disputes about money can be extremely damaging to personal relationships. There are also risks associated with third parties, including individuals and entities who may not be parties to the agreement. For example, if a parent loans money to a child who is married and that child later dies or goes through a divorce, the child's spouse may dispute the nature of the transaction and claim in probate court or in divorce court that it was a gift rather than a loan.
The IRS has guidelines for assessing whether a transaction is a gift or a loan. Their factors include:
- Is there a promissory note or other evidence of indebtedness
- Is interest charged
- Is there security or collateral
- Is there a fixed maturity date
- Was a demand for repayment made
- Was repayment made
- Did the transferee have the ability to repay
- Do the records maintained by the transferor and/or the transfeeree relect the transaction as a loan
- Was the transaction reported for Federal tax purposes as a loan
These factors are not exclusive. Overall, an actual expectation of repayment and an Intent to enforce the debt are critical for persuading the IRS that a transaction was a loan as opposed to a gift. Too many family loans do not involve a written agreement and do not charge any interest, and those omissions may leave the transaction vulnerable to challenge by other interested third parties.
If some of those factors are absent or suspect, the IRS may treat certain loans as gifts for income tax purposes, no matter what was the intent of the family and no matter how they behaved in regards to the agreement. The risk that a third party such as a spouse, a court, or the IRS, may treat a loan as a gift increases significantly if there is no written agreement or if the written agreement is poorly structured.
How a Lawyer Can Help You With an Family Loan
A properly-structured intrafamily loan can help the family members maximize the potential benefits of the loan while minimizing many of the risks associated with that type of loan. If the agreement is in writing, a third party spouse or a judge may be more likely to acknowledge the transaction as a loan rather than a gift. If the agreement includes an appropriate minimum interest rate, the parties may be able to insure that the IRS will view and treat the transaction as a loan as opposed to a gift. A well-written agreement can thus provide protection to both the lender and the borrower in the event of a challenge, no matter how unlikely a dispute is perceived to be at the time of the transaction.