Imputed interest may not have figured into the discussion when you were asking your family member to help fund your small business, but you can trust that the IRS will eventually get its cut.
If you plan to borrow money from someone you know to infuse cash into your business, do so with the following tax implications in mind:
A loan from someone you know becomes a gift loan if it has no-interest or an interest rate that’s below IRS minimums.
Borrowing from an acquaintance can get you money fast, but there can be consequences for the lender if they don’t charge you enough interest.
Before you get too eager about borrowing quick and cheap cash from a parent, relative, or friend, take a moment to brush up on the way imputed interest rates may affect your gift loan.
What is a Gift Loan?
A gift loan, also called a below-market loan, is one that is given with an interest rate of less than the Applicable Federal Rate (AFR) published by the IRS periodically.
For January 2020, the AFR table is below:
In the table, you see interest rates with corresponding loan terms; short-term, mid-term, and long-term.
Here are the term lengths for each one:
- Short-term loan – Up to 3 years
- Mid-term loan – 3 – 9 years
- Long-term loan – 9+ years
The difference between the AFR minimum and your gift loan’s interest rate is called forgone or imputed interest.
Essentially, this is the interest your lender should have collected in accordance with gift loan tax rules.
Your lender will have to pay income tax on this interest, even if they didn’t collect it from your loan!
What is Imputed Interest?
Say, your Uncle Joe loans you money with a 1% interest rate for one year.
The AFR rate for short-term loans is currently 1.11%.
The 0.11% he undercharged is still seen as taxable interest income.
Uncle Joe will need to calculate and report imputed interest to the IRS even though he didn’t profit from the small business loan.
This situation is one your lender will likely want to avoid since it can cost them cash and hassle.
It may seem like the IRS is being nitpicky about gift loan rules, but there’s a valid reason for it.
These rules surrounding gift loans are meant to deter taxpayers from giving away cash and other assets as low- or no-interest “loans” to avoid paying gift taxes.
Gift Loan Exceptions – How to Avoid Imputed Interest
Of course, like most tax codes, there are some exceptions to the rules.
Generally, if the loan has negligible tax effects on the lender and borrower, you don’t have to worry about imputed interest.
If someone gives you a loan for less than $10,000 and you’re not using the money to buy income-producing assets like stocks or bonds, you may also be exempt.
A microloan used to pay off business debts might fit into this narrow category.
There are also limits to how much imputed interest can impact a lender if the loan is under $100,000.
Imputed Interest & Gift Loans: Bottom Line
If you borrow money from family or friends, don’t expect it to be interest-free unless they don’t mind IRS gift loan tax complications (or if your use of the loan funds qualifies you for an exemption).
Instead, agree on a loan term, settle on an interest rate that meets AFR conditions, and put the agreement in an official document.
This way you both have an understanding of the repayment terms and you have proof of the arrangement to give the IRS if they question it.
AFR minimums are pretty competitive in comparison to other small business loans, business start up loans, and other financing options.
On the bright side, borrowing from someone you know can still be a very affordable approach to financing even if it’s not completely free.
Remember: You use our simple online form to begin the process of connecting with a lender.