Staying out of trouble with the IRS

From time to time we may get requests from friends or family to borrow some money. Some have strict policies about not lending to friends and family, which is a sure fire way to shorten the conversation. But others cannot resist the request and often find themselves as the bailout king or queen of the family.

If you are one who can’t resist lending or simply want to help, consider following some of these simple rules to help protect everyone involved in the private lending transaction.

First off, document the loan. Appropriate documentation may include a promissory note signed by all borrowers. For example, if your son wants to borrow money for whatever reason, have both he and his spouse or partner also sign to guarantee the debt. Wouldn’t it be horrible to see your son’s marriage end up in divorce court where he is the only one who legally owes the money?

In the case of a divorcing child, the promissory note protects you the lender and in this case your son if he isn’t the only borrower. If your son is the only borrower, then that debt may reside on his side of the balance sheet for negotiating the financial settlement of the marital estate.

Another reason could be for liability purposes. A friendly note without documentation could be the last bill paid if the borrower had a turbulent financial future or a potential bankruptcy. The issue with being the last bill paid in a financial settlement is that your repayment may be limited to whatever is left (if anything) after all secured or documented loans are paid back first.

Make sure the loan has repayment provisions and a reasonable interest rate. You can always relax these provisions during the repayment period if you’d like or if the borrower needs a little extra cushion. The repayment provisions are for everyone’s protection, including evidence the transaction was in fact a loan and not a gift. The fair rate of interest is something that makes good business sense and also keeps the transaction in conformity with IRS regulations regarding related party loans. In short, the IRS requires you have an interest rate attached to these loans or they can “impute” interest to the lender. Imputed interest means the IRS can tax you on interest income that you didn’t receive just because their rules say you should have received it. The IRS actually publishes rates each month on what are their minimum requirements for related party loans based on the duration of the loan.

If your secret intent is to make this loan a gift, but not all at once, you should still collect interest. Ask the borrower to pay interest only on the loan balance and forgive up to $15,000 of the loan each year.