Your Loan to A Start Up May Be Treated as a Gift

00009078When starting a business, it is common for entrepreneurs to seek initial funding from family and friends.  Since the holidays are creeping upon us, this means spending time with family members and loved ones.  During the festivities, discussions surrounding what people have been doing or planning on doing are bound to surface.  You may get pitched to make a loan to a new business venture during this holiday season.

If you plan on making a loan, you should probably start by reading the article, “No Good Deed Goes Untaxed, The IRS May Recharacterize Loans as Gifts” by Goldstein, Gomez, and Lannon.  The article raises a good points to consider regarding these start up type loans.  If the loans are not documented properly, they could be considered a gift and any portion about the annual gift exclusion could be counted against the lifeline gift tax.  The IRS could also consider the unpaid interest taxable in the year accrued.

The article recommends the following steps to make the funding be treated as a loan, and not a gift:

  1. The loan should be documented by a promissory note.”

  2. The promissory note should contain a fixed repayment schedule and a clear maturity date.”

  3. The loan should charge an adequate rate of interest (a safe harbor rate known as the “applicable federal rate,” which is quite low by commercial standards, is published monthly by the IRS).”

  4. The loan should actually be repaid by its terms.”

  5. The loan should be adequately secured.”

  6. The loan may be made to a “grantor trust,” which makes repayment of loan interest income tax free.”

So before making a loan to family member or friend this holiday season, make sure you document the loan terms adequately.

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