Family Loans

Loans to family members are common. Hardly a new business is started without one, and sooner or later, you will probably request or grant one of these non-commercial loans. Unfortunately, a great many intra-family obligations go bad. Can the lenders then recover part of their losses through a bad debt tax deduction?

It depends in large part on how the loan was made. It is very difficult to get an ordinary deduction unless the lender is in the business of making loans and this loan is part of the business. Only then can it be fully deductible as a bad debt write-off against business income.

If the debt is non-business, the loss is treated as a capital loss; therefore, it may be used to offset any capital gains the taxpayer may have. If there are no offsetting capital gains, the loss can offset other income up to $3,000 each year, with the excess carried over to future years.

In either case, however, the intra-family loan, unless it is properly documented, may be treated as a gift if it becomes uncollectible. Not only does this eliminate any income tax deduction, but it may also result in a gift tax.

Conditions
Any loan should be backed up with a note, formally stating the amount borrowed, repayment terms, interest to be paid and other details. This is particularly important for intra-family loans, which receive close IRS scrutiny in any circumstances.

In claiming a bad debt deduction for a loan that goes sour, one must be able to show that a real effort has been made to obtain repayment without success.

Problems Remain
There is even a risk in lending money to a family member if the business in which it is used proves to be a big success. The danger is that the IRS, under provisions of current tax laws aimed at estate tax evasion, might decide that the loan is, in fact, an equity investment.

For instance, perhaps a son or daughter has a small business worth $100,000. The company needs another $200,000 of capital for expansion, which you provide in the form of a loan duly supported by a note calling for the prevailing interest rate and a specified schedule of repayments. The business succeeds. In such a situation, at your death, $150,000 of the loan is still owed. It is now payable to your estate. However, the IRS may look at the arrangement and categorize it as tantamount to a large equity investment on your part. That could mean a substantial increase in your gross estate.

To avoid this, watch for the following:

• The loan must not convey any lender rights except repayment.
  For example, no future profit sharing or voting rights may be conveyed.
• Do not serve as consultant, board member or employee.
  You should not serve as a consultant, board member or even part-time employee unless your compensation is not excessive and the term of the contract for your service does not exceed three years from the loan’s date.
• Specify that the loan cannot be subordinated to creditors.
• Do not allow the term of the loan to exceed 15 years.
• Provide/follow fixed repayment of principal and interest.

In any case, it is essential that you consult with an attorney and make the loan by the book.