Scarinci Hollenbeck, LLC, LLCScarinci Hollenbeck, LLC, LLC

Firm Insights

Imputed Interest, Gifts and Family Loans

Author: James F. McDonough

Date: April 15, 2014

Key Contacts

Back

Family Loans are an integral part of life, as well as estate and gift tax planning.  Until the IRS victory in Dickman in 1980, interest-free loans were a staple of tax planning. Today, however, the rules that apply are designed to force interest income to be reported, even if not paid.  Certified Public Accountants (CPAs) encounter these rules in preparing returns and must comply. Those familiar with the topic know that a complete discussion is beyond the scope of a blog, but here are some common misunderstandings.

The first issue is whether the loan is a term loan or a demand loan.  Invariably, family members do not execute notes reciting interest rates, so CPAs are forced to apply the demand loan rules. Each year, the IRS publishes an interest rate in January and again in July with each rate applying for six months. If the loan remains outstanding, the taxpayer may use a blended rate to calculate the interest that must be reported. Where the taxpayer does not keep good records, it is especially difficult to address the issues after the death of the taxpayer and to prepare an inheritance or estate tax return. Was it a gift or are the income tax returns wrong.

What makes matters more difficult is that the borrower, typically a child, sometimes pays irregularly. Fortunately, the rules provide that each payment reduces the balance and a new loan is created on the following day using the “exact” or “approximate” method.  Once again, the process requires record keeping which is beyond the reach of many individuals.

The duration of a term loan causes an appropriate rate of interest to be assigned by IRS. Where taxpayer’s interest rate is below the rate required by IRS, Original Issue Discount (“OID”) must be charged. The lender’s income tax return not only must report income but also must recite five (5) items in a statement attached to the return.  The borrower’s return must contain a similar statement. Despite the fact the rules have been around for years, most taxpayers do not realize that OID applies to cash-basis taxpayers.

Below market term and gift loans require the lender to report the forgone interest as a gift on the last day of the year. Loans with adequate interest do not have to report forgone interest; however, accrued but unpaid interest requires OID reporting.

Sales of property for less than fair market value pose a problem. Is the transaction a gift of the bargain portion or is it a below market loan? When the present value of the payments is less than the face value of the loan, it is OID. This is, perhaps, the most overlooked issue in tax.  The tax preparer’s nightmare is when the value, appraised or not, undervalues the gift. Not only are there estate and gift tax consequences, but also there are income tax.

No where does this area become more obtuse than an interfamily installment sale to a child of property to be used in business.  Many contend that §483(e) applies exclusively and application of §7872 is precluded by §7872(f)(8) and the  Frazee  case.   Yet for all the complexity, no one can deny that loaning funds to a child to buy a house or start a business.  Funds loaned today on a ten year loan at 3.3% may transfer substantial wealth over the long term.  Despite the rules, family loans have substantial benefits.

No Aspect of the advertisement has been approved by the Supreme Court. Results may vary depending on your particular facts and legal circumstances.

Scarinci Hollenbeck, LLC, LLC

Related Posts

See all
Why Secured Transactions Are Important post image

Why Secured Transactions Are Important

Secured transactions form the backbone of a wide range of business dealings, including business loans, mortgages, and inventory financing. Because the stakes are often high and relatively minor oversights can have drastic consequences, lenders and borrowers should thoroughly understand how to form an enforceable security agreement that protects their legal rights. What Is a Secured […]

Author: Dan Brecher

Link to post with title - "Why Secured Transactions Are Important"
Don’t Cash a “Paid in Full” Check Without Understanding the Legal Implications post image

Don’t Cash a “Paid in Full” Check Without Understanding the Legal Implications

Cashing a check marked “paid in full” can be a risky endeavor, particularly if you don’t fully understanding the legal implications. If you are owed more than the amount of the check you accept and deposit, you may waive your right to collect the full disputed amount. That is why you should consider either rejecting […]

Author: Dan Brecher

Link to post with title - "Don’t Cash a “Paid in Full” Check Without Understanding the Legal Implications"
Changes to Qualified Small Business Stock Will Benefit Startup Founders and Investors post image

Changes to Qualified Small Business Stock Will Benefit Startup Founders and Investors

The One Big Beautiful Bill Act of 2025 (OBBBA) significantly impacts federal taxes, credits, and deductions. A key change relating to Qualified Small Business Stock (QSBS) allows greater tax-free gains for investments in startups and other qualifying small businesses. Company founders and other investors should understand how the enhanced tax strategy works or risk missing […]

Author: Dan Brecher

Link to post with title - "Changes to Qualified Small Business Stock Will Benefit Startup Founders and Investors"
Corporate Consolidation and Antitrust Issues in Mergers post image

Corporate Consolidation and Antitrust Issues in Mergers

Corporate consolidation involves two or more businesses merging to become a single larger entity. The result is often a stronger and more competitive company that can better navigate today’s competitive marketplace. What Is Corporate Consolidation? Corporate consolidation closely resembles a basic merger transaction. The primary difference is that a consolidation creates an entirely new business […]

Author: Dan Brecher

Link to post with title - "Corporate Consolidation and Antitrust Issues in Mergers"
What is Business Law and Why Is it Important? post image

What is Business Law and Why Is it Important?

Business law plays a critical role in nearly every aspect of running a successful enterprise, from negotiating a commercial lease to drafting employee policies to fulfilling corporate disclosure obligations. Understanding what is business law and your legal obligations can help your business run smoothly and build productive relationships with clients, business partners, regulators, and others. […]

Author: Dan Brecher

Link to post with title - "What is Business Law and Why Is it Important?"
Corporate Transactions: Best Practices for Successful Deals post image

Corporate Transactions: Best Practices for Successful Deals

Corporate transactions can have significant implications for a corporation and its stakeholders. For deals to be successful, companies must act strategically to maximize value and minimize risk. It is also important to fully understand the legal and financial ramifications of corporate transactions, both in the near and long term. Understanding Corporate Transactions The term “corporate […]

Author: Dan Brecher

Link to post with title - "Corporate Transactions: Best Practices for Successful Deals"

No Aspect of the advertisement has been approved by the Supreme Court. Results may vary depending on your particular facts and legal circumstances.

Sign up to get the latest from our attorneys!

Explore What Matters Most to You.

Consider subscribing to our Firm Insights mailing list by clicking the button below so you can keep up to date with the firm`s latest articles covering various legal topics.

Stay informed and inspired with the latest updates, insights, and events from Scarinci Hollenbeck. Our resource library provides valuable content across a range of categories to keep you connected and ahead of the curve.

Let`s get in touch!

* The use of the Internet or this form for communication with the firm or any individual member of the firm does not establish an attorney-client relationship. Confidential or time-sensitive information should not be sent through this form. By providing a telephone number and submitting this form you are consenting to be contacted by SMS text message. Message & data rates may apply. Message frequency may vary. You can reply STOP to opt-out of further messaging.

Sign up to get the latest from the Scarinci Hollenbeck, LLC attorneys!