Introduction
Are you a business owner, parent, grandparent or other relative interested in allowing someone close to you to borrow money? Or are you even interested in giving them a sum of money greater than the current gift tax limit ($16,000 in 2022)? There are some things you should consider.
Gift Tax
As a general concept, Gift Tax exists in order to prevent tax evasion (specifically estate taxes and others) by placing limits on financial or asset gifts to anyone other than your spouse. The cap on gifts does change occasionally, so be sure to keep up to date with the current limit. There are strategic gifting options available. These strategies are often executed in concert with your CPA and an attorney, but will likely still require you to charge a minimal interest rate based on the AFR rate discussed below.
Acceptable Federal Rates (AFR)
You can view the most recent Federal AFR rates here: IRS AFR RATES
The AFR Rates are updated monthly by the IRS and published for reference by anyone with an internet connection. In essence, this is the minimal rate of interest that must be charged when making a private loan to any individual (usually family).
Example
An example of this would be the sale of a business to an existing manager or employee. Sometimes, the employee is unable to get private financing to effectuate the full purchase all at one time. Thus, the departing owner will “owner finance” the full or remaining balance required. This creates an installment sale, allowing the seller to spread out any potential tax liability associated with the capital gain over the duration of the installments (e.g. 10 years). Often times, the business owner doesn’t want to charge interest as they feel it is a bit self serving or greedy to do so.
Unfortunately, charging 0% interest is not an option in most cases. Whether they know at the time or not, the seller is ultimately receiving some favorable tax treatment as a result of the installment sale. Thus, in exchange for this treatment, the IRS mandates that the seller utilize the AFR rate pertaining to the balance of the loan granted. This assures that, at the very least, the seller will claim some income (and thus pay some income tax) on the interest he/she/it receives over the years.
Conclusion
If you plan to sell your business, pass it along to a family member, friend, or key member of your team, be sure to reach out to your CPA and/or attorney to ensure that you have a plan to execute the transaction correctly the first time. You’re welcome to call our office at (904) 990-7777 to schedule a free consultation, or visit our Contact Us page and someone will get back to you ASAP.