Q: I want to make a $175,000 gift to my daughter and son-in-law. I know I can give $15,000 each without tax reporting. I was advised to give $30,000 this year and have them sign a note for $145,000. I will then forgive $30,000 each year until the loan is paid. This is supposed to be a gift of $30,000 each year. Do you think this is an effective strategy?
A: This is an old planning idea that is common enough to acquire its own name — an installment gift. When challenged it has not generally been successful.
The issue is what was intended when the funds were first transferred. A loan is a transfer with the expectation of repayment. If the transferor of the funds never intends to enforce repayment, there is no loan.
Abraham Lincoln used to ask, how many legs does a dog have if you call its tail a leg? The correct answer: four. Just calling a tail a leg does not make it so. Recall that Lincoln was a lawyer.
The tax law does not respect the names that people attach to things unless the substance of the thing matches the name. Just calling a transfer of funds a loan does not make it so.
It is certainly possible for someone to transfer money with an initial expectation of repayment, and then later experience a change of heart and not seek repayment. The challenge is determining intent.
When a large loan calls for annual payments within the gift tax exclusion, and each payment is forgiven, it may be difficult to argue that there was a loan. The fewer times forgiveness happens, the better is the argument that a loan existed.
People have been successful when the loan was made to purchase real estate and the loan is secured by a note and mortgage. The ability to enforce the terms strengthens the appearance of a loan.
In the end, you are the one who best knows your intent. If your actions might appear at odds with your intent, you should document your original intent and why it changed, at least as best that you can.
Q: Are there special tax rules for deducting salary paid to a family member? I have owned my own business, which is an S corporation, for 35 years. My 32-year-old son is very talented, has an MBA, and earns $130,000 working for another company. I have always wanted him to work for me and he has resisted because he said he needs to prove himself in the market. I am trying to get him to come to my company so I can start to wind down to retirement. We have talked about this for a year and he says it would take a $50,000 raise for him to change companies. I am willing to pay him $180,000 but I wonder if the IRS will claim I am making a gift for some of his pay. How does IRS determine what is fair pay?
A: There is no question that payment made to related parties are scrutinized more closely to determine the proper tax treatment. This is not just for salary.
Compensation paid to an employee is deductible if it is ordinary and necessary. Courts have said there is an implicit requirement that the pay be reasonable to be ordinary and necessary.
This issue is common in family-controlled businesses. You have a fairly strong position because your son has “prove[d] himself” worth $130,000 to a third-party employer.
With professional workers, it is common to demand more pay to change employment. I can’t say that $180,000 is reasonable for your son, nor can the IRS. Reasonable pay is never a single amount, but rather a range.
Your facts seem favorable. Your son has a history of working for others at a high pay, and the two of you seem to have negotiated for the past year to determine his “reservation” wage and what you are willing to pay.
Your question seems to imply that the same type of negotiations took place between you and your son that would have occurred between unrelated parties. So, no guarantees, but you seem to be on solid ground.
James R. Hamill is the Director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at firstname.lastname@example.org.