Family loans and loan guarantees.

Borrowing from a family member or having a relative guarantee a loan can be vital to the economic well-being of certain individuals. Unfortunately, these loans often are granted in less than ideal economic situations, increasing the probability of default and inviting Internal Revenue Service scrutiny of any related bad debt deductions. Without careful planning at the outset, family members may find

* A conflict in the tax goals of borrowers and lenders.

* The loans or guarantees subject to strict IPS scrutiny.

* The unpaid loan balances or loan guarantees deemed taxable gifts.

This article reviews the related tax problems and offers planning ideas for overcoming them. This knowledge should help CPAs prevent clients from having well-intentioned transactions between family members undermined by unfavorable tax consequences.

FAMILY LOAN DEFAULTS

A lender generally can claim an ordinary tax loss for a bad debt arising from a loan made in connection with the lender's business. When the borrower is a related entity controlled by noncorporate relatives, however, the courts have consistently ruled against ordinary loss treatment for such bad debts. Instead, taxpayers must try to qualify for a nonbusiness bad debt deduction.

Under Internal Revenue Code section 166(d), a nonbusiness bad debt deduction is treated as a short-term capital loss, the value of which depends on the lender's investment and tax situation. Short-term capital losses first offset short-term capital gains (such as those from stock investments); any excess offsets long-term capital gains. If short-term capital losses exceed both short- and long-term capital gains, the excess offsets up to $3,000 of ordinary income in the year the losses occur, with any remaining balance carried forward to future years.

QUALIFYING FOR BAD DEBT DEDUCTION

Two conditions must be met to deduct nonbusiness bad debts.

Bonafide. The debt must be bona fide. Under Treasury regulations section 1.166-1(c), a bona fide debt arises from a debtor-creditor relationship based on a valid and enforceable obligation to pay a fixed or determinable sum of money.

Worthless. The debt must be completely worthless with no reasonable prospect of future recovery or payment. Unlike business bad debts, IPC section 166(a)(1)(a) provides that partial worthlessness of a nonbusiness bad debt will not produce a deduction. Regulations section 1.166-2(a) says complete worthlessness depends on the facts and circumstances, including the value of any collateral and the debtor's financial condition.

Proving a debt is bonafide. The Ninth Circuit Court of Appeals, in Zimmerman, said proving a debt is bona fide requires taxpayers to show the obligation to repay is not contingent and is made with a reasonable expectation, belief and intention to repay. Following Zimmerman, the courts have held that while the riskiness of a loan is not a contingency invalidating its bona fide nature, repayment depending on the profitability of the borrower's operations is such a contingency.

To determine whether a loan is made with reasonable expectation, belief and intention to repay, the courts generally use a facts-and-circumstances approach. Factors commonly considered include whether

* A note or other evidence of indebtedness exists.

* Interest is charged.

* There is a fixed repayment schedule.

* Any security or collateral is requested.

* There is a written loan agreement.

* A demand for repayment has been made.

* The parties' records, if any, reflect the transaction as a loan.

* Any repayment has been made.

* The borrower was solvent at the time of the loan.

These factors apply equally to determining whether a loan to an unrelated party is bona fide, but the standard of proof for family loans generally is higher. Taxpayers must carefully document each factor to prove a family loan's bona fide nature.

Proving worthlessness. When legal action to enforce payment would be fruitless, regulations section 1.166-2(b) says taxpayers do not have to file suit to meet the burden of proving worthlessness. They must, however, make a bona fide attempt to collect the debt to ensure a deduction.

Such an attempt seldom is at issue if the borrower is an unrelated party because the economics of the transaction dictate that the lender make all reasonable efforts to seek repayment. When the borrower is related to the lender, however, the lender may feel uncomfortable pursuing payment with the same intensity--particularly if the, relative is a son or daughter. But unless the related borrower becomes insolvent or bankrupt and is unlikely to recover financially to the point where the loan can be repaid, the lender can expect the IRS to deny a deduction.

HOW THE IRS DENIES A DEDUCTION The IRS denies nonbusiness bad debt deductions by treating the lender as having made a gift equal to the remaining loan balance when the statute of limitations expires. Even though the running of the statute does not extinguish the debt--it merely creates an affirmative defense in a collection suit--the IPS has successfully used this treatment. The lender then is a double tax loser: The nonbusiness bad debt deduction is lost, and the lender has made a gift equal to the forgiven debt. If the remaining loan balance is more than the annual $10,000 per-donee gift-tax exclusion ($20,000 if the spouse joins in the gift), the lender must use part of his or her unified estate tax credit to shelter the gift from tax.

Effect on borrower. Whether the lender gratuitously forgives or is forced by the IPS to forgive the outstanding balance on a loan to a related borrower, the borrower will not have taxable income under IRC section 102(a). If the transaction is treated as a nonbusiness bad debt, however, IRC sections 61(a)(12) and 108 provide that the borrower will have fully taxable forgiveness of debt income, unless he or she is insolvent or bankrupt.

POSSIBLE TAX STRATEGIES

Tax practitioners have no easy answers for clients holding loans from family members who cannot or will not pay. However, as the following examples show, there are strategies for minimizing the damage to the lender when default occurs.

Example. Jan Brinson borrows $100,000 from her mother to open a fashion boutique. All debtor-creditor formalities are observed (including a written instrument, adequate interest under IPC section 7872 and a fixed repayment schedule); jan is solvent when the note is executed. After she has repaid $50,000 of the loan, Jan's business fails, and she returns to her previous job at a large reduction in salary. Althoughjan is still solvent, she clearly is unable to repay the $50,000 loan balance.

To substantiate her tax position, jan's mother should make a formal notice and demand for payment that will document an attempt to collect. A possible strategy then is to try to obtain assets in partial satisfaction of the debt--for example, accept $10,000 of jewelry from Jan--and release Jan from payment of the balance. Jan's mother can claim the $40,000 balance is worthless and try for a bad debt deduction. Another strategy, common to lenders in arm's length transactions, is to reduce the outstanding debt to a level jan can manage, stretch. out the repayment time and write off the rest. Presumably, jan can offset some of the forgiveness of indebtedness income with losses from the failed business.

Example. John Hill's parents lend him $200,000 so he and his wife can buy a home. The loan, backed by a written agreement, calls for annual principal and interest payments (at an adequate interest rate under section 7872) over 15 years. After making payments for three years, John has a conflict with his boss and quits his job. His short-term prospects for finding a new job are weak. John's wife continues to work, enabling them to continue making the loan payments, but only if they drastically change their lifestyle.

Clearly, the loan to John is not uncollectible; thus, John's parents can't claim a bad debt deduction. However, they may be able to minimize the possible gift tax consequences. One strategy to explore is for John's parents to forgive part of the remaining loan balance each year in an amount equal to the per-donee gift tax exclusion. John, however, should continue paying interest on the outstanding balance if he is able to. Otherwise, Treasury regulations section 1.7872-11 will impute interest income to his parents and treat them as having made a gift of the forgone interest. John's parents can stop the yearly gifts when John's financial condition improves.

If the purpose of a family loan is to help with education or medical expenses, family members can avoid IRS scrutiny by paying the costs directly. IRC section 2503(e) says any amount paid on behalf of an individual for tuition to an educational institution or to a medical services provider is not a transfer of property by gift.

FAMILY LOAN GUARANTEES

Guaranteeing a family member's loan, particularly a child's, is another well-intentioned tactic that may be critical to the economic well-being of family members but may have adverse consequences if the tax aspects are overlooked. An IRS private letter ruling shows that the service has an aggressive policy for a parent's personal guarantee of a child's business loan.

Letter ruling 9113009. The children at issue here were in a business that acquired equity positions exceeding $1 million in each of several companies. The purchases were financed with large bank loans made to the children's acquiring companies. The children's father personally guaranteed the loans, receiving nothing in return. The loans probably would not have been made without the father's guarantees, or at least would have carried higher interest rates.

The IRS ruled that when the father signed the guarantees, he conferred valuable economic benefits on his children; these benefits were transfers subject to gift tax. In addition, the IRS ruled that if the father had to make good on the guarantees, his payments would constitute additional gifts. The IRS based its ruling, in part, on the U.S. Supreme Court decision in Dickman in which, in holding that an interest-free loan constituted a taxable gift, the Court illustrated the principle that "the gift tax was designed to encompass all transfers of property and property rights having significant value."

Coping with the ruling. The IRS ruling is a cause for concern because of the implications it holds for the

* Valuation of benefits conferred by guarantees.

* Treatment of personal loan guarantees.

* Treatment of direct loans.

Valuation. Valuing loan guarantees for gift tax purposes is certain to be a controversial issue for clients confronted with the IRS's stance in the letter ruling. The IRS never gives advance rulings on valuation issues, automatically increasing the likelihood of disagreement. When a loan probably would not be made without a guarantee, there is no economic reference for valuing the benefit. When a loan would be made only at a higher interest rate, the present value of interest payments with the guarantee less their present value without it seems a reasonable way to value the benefit. However, the IRS is likely to challenge this technique because of the uncertainty surrounding the variables involved in the present value computations.

Treatment of personal loans. The letter ruling dealt only with business loans involving large sums of money. But will the IRS also attack the guarantee or cosigning of personal loans, such as those for cars and homes? The value of a personal loan guarantee in most cases will not exceed the annual gift tax exclusion and, thus, will not generate a taxable gift. However, once the annual exclusion is used to cover the guarantee, it will not be available for outright transfers.

Impact on direct loans. Section 7872 says a parent making a direct loan to a child with interest equal to or exceeding the applicable federal rate has not made a taxable gift. However, could the IRS use an interpretation of Dickman to establish a taxable gift if the child could not obtain a loan without the parent's guarantee or if the child could obtain a commercial loan only with a higher interest rate? Going a step further, why should a parent be considered as having made a taxable gift when guaranteeing a loan but not when making a direct loan at adequate interest? Only time will reveal the IRS's comprehensive strategy in this area.

DOING IT RIGHT IN THE FUTURE

Family loans and loan guarantees often are made without CPAs' help. Consequently, tax practitioners can offer little assistance to families who have had loans go sour or who have made loan guarantees. However, they can tell clients about the potential tax problems of future family loans or loan guarantees and remind them of the help practitioners can offer.

RELATED ARTICLE: EXECUTIVE SUMMARY

* FAMILY LOANS AND LOAN GUARANTEES can have unfavorable income and gift tax consequences and invite unwanted Internal Revenue Service scrutiny. Careful planning is needed to avoid conflicts in the tax goals of borrowers and lenders.

* IF FAMILY MEMBERS DEFAULT ON LOANS, taxpayers generally must try to qualify for a nonbusiness bad debt deduction, which is treated as a short-term capital loss. To qualify, the debt must meet certain requirements as a bona fide debt that is judged to be worthless.

* IN DENYING BAD DEBT DEDUCTIONS, THE IRS treats the lender as having made a gift equal to the remaining loan balance. The taxpayer loses the deduction and may face problems if the "gift" exceeds the $10,000 annual gift tax exclusion.

* FAMILY LOAN GUARANTEES CAN CREATE simlar gift-related problems, as well as difficulties in valuing the guarantee, particularly if the loan would not have been made without it.

* WHILE CPAs CAN OFFER LITTLE HELP TO families who have had loans and loan guarantees go sour, they can advise all other clients about the potential tax consequences and offer to provide advance assistance.

LEE G. KNIGHT, Phd, is E. H. Sherman Professor of Accountancy at Troy State University, Troy, Alabama. RAY A. KNIGHT, CPA, JD, is an independent consultant in Troy.

RELATED ARTICLE: Warning of the Risks of Family Loans

Beth C. Gamel, CPA and executive vice-president of Tax B& Financial Advisors in Lexington, Massachusetts, is a financial and estate planning specialist. Many of her clients are wealthy parents who want to help their adult children financially, either through loans or gifts. "It is important to make it clear to them that family loans can go bad," she says. Gamel tells clients that their children may not be able to repay the loan, not because they do not want to, but because circumstances in their lives could change.

Gamel next offers a series of suggestions, or creative alternatives, to family loans. "When my clients want to help their children buy a house, and the children do not look like they can pay back a loan to buy it, I ask them if they want their children to own a house or if they just want them to have a place to live," Gamel said. "I suggest they offer their children a gift of enough money so they can afford to rent a nice place, or I may suggest that they buy the house for them and get the mortgage interest deduction. The children can ultimately buy the house from their parents or the parents can make a gift of it to their children later."

One of Gamel's clients gave $10,000 gift to each of her children each year and paid her grandchildren's college tuitions. A son-in-law also needed a loan to shore up a troubled business, but he never repaid it. "As the years went by it was very frustrating for my client," said Gamel. "I suggested that because this daughter and son-in-law had no children, my client could equalize what she gave to each of her children by forgiving the debt. She forgave it over three tax years at $10,000 per year, hoping her son-in-law could stay current with the interest payments."

Because of the real risk in family loans, Gamel always advises her clients to draft a promissory note for any loan, which not only provides documentation for bad debt deductions but adds legitimacy to family transactions.

The Direct Approach

Stanley Person, CPA and partner of Person & Company in New York City, gives the same advice, and his overall philosophy is to be very straightforward. He asks his clients considering family loans whether or not they are willing to sue a family member. "It is a test I give my clients up front to remind them of the sensitive problems that can arise," said Person. "For example, a client recently wanted to help a son start a business. I asked him if he was comfortable with the fact that he might not get his money back. I also told him he could not participate in the business because any ultimate loss would be considered a capital loss and not a loan."

After Person is certain clients understand the ramifications of family loans he drafts the proper documentation. "With few exceptions, if there is proper documentation, whether it is an unrecorded mortgage or a promissory note, my client will take the bad debt deduction," said Person. He said it is important to use the applicable federal rates for repayment agreements to further substantiate an arm's length agreement. "Good documentation will support the deduction as long as it is not a casual loan, like a series of loans over a number of years that are not used to buy a house or business," said Person. "If parents gave $100,000 to their children to buy a house, with no documentation they'd lose all control if their child and spouse decided to divorce," said Person. "If it is a documented loan, the parents can assert their legal rights to the house."

When possible, person will advise his clients to use a third-party lender--possibly a profesional, a family friend or a trust. "The broblem with family loans is that borrowers will pay all of their other obligations before they pay back their families," said Person. "The third party creates a stronger sense of responsibility." One of Person's clients wanted to advance money to each of her 14 grandchildren. Person suggested she set up a long-range fund from which her family could borrow. "Her family was not borrowing money from their parents or grandparents, they were borrowing from the family trust, and they had to repay it."