The COVID-19 pandemic has caused a great deal of financial hardship for individuals and families. If you are in a position of financial security, you may be thinking of lending money to struggling family members or close friends. A little bit of help in these challenging times may be just what your loved ones need to get through until they can find work and get back on their feet again. While lending money to close family and friends is a kind gesture on your part, you should be aware that there are tax implications to plan ahead for.
Use Paperwork
First off, be sure to use formal documentation—a promissory note—for any loan that you’re offering. This protects you, the loan recipient and your personal relationship with the friend or family member. You’re better protected with formal documentation for tax purposes, as is the loan recipient. Your relationship is protected because both of you will understand what is expected in the terms of the loan. There can be no misunderstanding or arguments when the transaction terms are laid out in black and white. Use a promissory note whether or not you decide to charge interest on your loan.
Keep the Loan Under $10,000
If you plan on offering an interest-free loan to someone, you probably want to keep it under $10,000. Why? Because more than that and you’ll be subject to “below market interest rules.” This means that even though you’re not charging interest on the loan, you have to pay income tax on the interest – at the applicable federal rate, which is updated monthly by the IRS. In effect, you’ll be forking over more than the loan principal in the form of taxes paid on interest you haven’t even received. If your loan amount is less than $10,000, however, you aren’t required to declare interest income on your tax return as long as the borrower doesn’t use the loan money to purchase or make payments on assets that produce income, such as business equipment or real estate rental property.
Another option is just to charge nominal interest on a loan over $10,000, but be careful here, too. If you decide to be generous and charge your loved one less than the market rate (published in the monthly IRS bulletin), you still have to declare market rate interest earned.
Finally, if you lend over $10,000 and don’t charge interest and then you get audited, the IRS can decide that your loan was not a loan at all, but a gift. In this case, you may need to pay gift tax, which, is, by default, the responsibility of the donor, not the recipient. Your CPA can give you details of what a gift tax would entail in your situation, depending upon the loan amount.
The Borrower and Interest Deductions
In the majority of cases, the loan recipient cannot deduct the interest that they pay on the loan you give them. The exception to this rule is if the loan is secured by the home of the recipient. If this is the case, then the borrower can deduct the interest as “qualified residence interest.” Of course, you would likely not secure a home to the loan unless it was a substantial amount.
Alternatives to Friends and Family Loans
If you’re just eager to help out struggling friends and family and you want to avoid tax implications, you have some alternatives:
Consider a Gift
If the money is going from a parent to a child (adult or otherwise), know that each parent can give up to $15,000 to a child once a year, tax free, for a potential total of $30,000.
If you just want to help out in a small way, consider a gift of up to $599, which does not need to be claimed on either person’s tax return. Income from any source in a year totaling $600 or more does need to be declared on the recipient’s tax return.
Consider Temporary Employment
You can also help out a struggling friend or family member by offering them a temporary contract job through your small business. This might be a better solution if you feel their hardship may be lasting, or if they are more comfortable earning the money instead of just taking “free” money. As an independent contractor, they would be responsible for paying income taxes and withholding on the money earned, but you would not have to pay payroll tax. Your friend or family member could do work such as:
- Design a new website for your business
- Provide landscaping services for your business
- Provide cleaning services for your business
- Run company errands
- Write copy for your business marketing purposes
- Conduct business research on your behalf
- Do data entry
- Answer business calls
- Act as your office assistant
As with all money-related transactions, be sure to create and sign an independent contractor agreement with your friend or family member so that the terms are clear for both parties. If the assistance is to be temporary, be sure to lay that out in the contract, too.
As you can see, there are all kinds of ways to be generous with your money in these unstable times. But it pays to be smart about lending or giving money away, too. If you are planning to lend or give money, consult with your CPA first so that you can make an informed decision about how much to give and how to structure the transaction. Otherwise, you could end up paying more in taxes than you originally bargained for, which isn’t on anyone’s wish list.