Intrafamily Loans – IRC Sec. 7872

Intrafamily Loans – IRC Sec. 7872

By Adam J. Gottlieb

            Before 1984, a high-income taxpayer could loan money to a lower income taxpayer without charging interest on the loan and the loan terms would be respected on their face. For example, a parent could loan money to his or her child without charging interest. The child could earn income on that borrowed money, which would be taxable to the child at his or her lower income tax rate, and the parent would earn no income on the loan because there would be no interest charged to the child. However, in 1984, after several unsuccessful attacks by the Internal Revenue Service, the U.S. Supreme Court decided Dickman v. Commissioner, 465 U.S. 330, 104 S. Ct. 1086, 79 L. Ed. 2d 343 (1984), and §7872 was enacted.
            The statute distinguishes between those loans that have a stated term (“term loans”) and those that do not (“demand loans”). Loans (Term and Demand) in which the Applicable Federal Rate exceeds the charged rate are called below-market loans. The statute also provides the framework for a tax fiction in which the forgone interest is deemed transferred by the lender to the borrower, and then retransferred by the borrower to the lender as interest, even though no payments were actually made. Further, the deemed gift must be computed for both gift and income tax purposes to determine the amount. 
            There are two limited exceptions to the imputed interest rules detailed above relating to gift loans, which are loans for which the forgone interest is in the nature of a gift, rather than compensation or some other nature:

 

1.       De minimis exception. A loan of $10,000 or less between individuals only—an entity may not be a party to the loan—does not require the imputation of interest if the amount of the outstanding balance of the loan does not exceed $10,000 at any time. 
2.       Safe harbor. If the balance of a loan between individuals does not exceed $100,000 at any time, the §7872 does not require the imputation of interest. This exception applies only when the borrower’s and his or her spouse’s net investment income for the year (gross income from taxable interest, dividends, rents, royalties, and gains from investment assets, reduced by investment expenses) does not exceed $1,000. If the net investment income of the borrower and his or her spouse exceeds $1,000, the amount of the net investment income is imputed to the lender. If such income does not, then it is ignored with regard to §7872. Since a loan under $100,000 could subject the lender to income and gift tax if the borrower’s and his or her spouse’s income is too high, planning the borrower’s investment of the loan proceeds may make a difference. 

 

  1.  
    1. Purchase tax-exempt investments, such as municipal bonds, since the definition of net investment income does not include tax-exempt income. 
    2. If the borrower can alter the timing of the receipt of the net investment income, then the $100,000 exception does not apply. This may occur if the borrower owns a controlling stake of a closely-held corporation and dividends may be paid at the discretion of the shareholders. 
    3. Purchase nonincome-producing assets. The borrower’s purchase of a personal residence may produce no net investment income. 
    4. Finally, the low interest rate environment in which we live makes it a bit easier to keep the borrower’s net investment income low as well.
With a little careful planning, the lender may be able to assist a borrower without causing a taxable event to himself or herself.