Who pays interest on loan to child?

April 1, 2006
Last year, I loaned my son $50,000 for a down payment on his home and elected not to charge him interest on this loan.

Last year, I loaned my son $50,000 for a down payment on his home and elected not to charge him interest on this loan. Recently, I heard that I would have to pay tax as if I had actually charged interest on this loan. Is this correct?

If your son’s net investment income exceeded $1,000, you would have to determine the “foregone” interest based upon the IRS approved interest rate at the time you made the gift loan. In order to determine this rate, you should go to the IRS Web site (www.irs.gov) and search for “AFR.”

However, the interest income that you report will not exceed your son’s net investment income. For example, if the foregone interest amount was $3,000, and your son had only $1,000 of net investment income, you would have to report only $1,000 of interest income on your return.

With rising short-term interest rates, I recently invested in some six-month Treasury Bills at auction. These bills mature in March. Will I owe tax on any interest income on my 2005 federal income tax return?

The Treasury auctions six-month Treasury Bills at a discount from face value and no interest is paid until maturity in March of 2006. Since you did not collect any interest income in 2005, you have no taxable income to report. Rather, the difference between your cost and the proceeds received at maturity is considered interest income, not capital gain, and is properly reported on your 2006 income tax returns.

My son inherited some stock from his grandfather several years ago. Last year, the stock earned $1,400 in dividends and capital gains. Is this income subject to the “kiddie tax?”

No it isn’t, as long as your son had no other investment income. The kiddie tax applies the parents’ marginal tax rate to the child’s income to the extent that it exceeds $1,600. As long as your child had no other investment income, this $1,400 of income would be properly reported on his return, where only minimal income taxes would be owed.

I own some real estate that has appreciated in value, and I am thinking about selling it soon. I also have two children who will begin college next year. Is it possible for me to put this property in their names prior to the sale and generate some tax savings by doing so?

Since your children are aged 14 or older, any investment income, including capital gains from the sale of land, will be taxed to them at their rate, which could be as low as 5 percent. Your children will take the property with the same cost basis and holding period that you enjoy.

If your children are not adults under state law, they cannot legally contract to sell the land or transfer it. As a result, you may need to create a family limited partnership (FLP) or limited liability company (LLC) to take title to the property, says Blake Hassan, a tax attorney and CPA with McGill and Hassan, P.A. (704) 424-5450.

For more information on ways to dramatically cut college costs, send a self-addressed, stamped envelope to John K. McGill & Company, 2810 Coliseum Centre Drive, Suite 360, Charlotte, NC 28217, and request “How to Transfer over $100,000 of Income Tax-Free to Your College.”

My corporation just converted my profit-sharing plan of many years into a defined-benefit pension plan in order to increase my tax-deductible savings for retirement. My personal living expenses are lower now that my three children are out of college and my home mortgage is paid. I would like to reduce my salary so that I can increase my defined-benefit plan contribution. Can I do this or must I keep my salary at the maximum level ($210,000 for 2005), to get the maximum tax-deductible contribution?

Yes, says Jason Arnold, East Coast District Manager of PenSys, Inc. (888) 440-6401, a retirement plan consulting firm. Provided that your plan document allows contributions to be based on the highest three-year average compensation and your compensation for at least three consecutive years has been at the IRS maximum limit, you should be able to reduce your current salary and increase tax-deductible contributions to the defined-benefit pension plan to the maximum amount actuarially possible.

John K. McGill is a tax attorney, CPA, and MBA, and is the editor of The McGill Advisory, a monthly newsletter helping dentists to maximize profitability, slash taxes, and protect assets. The newsletter ($209 a year) and consulting information are available from John K. McGill and Company, 2810 Coliseum Centre Drive, Suite 360, Charlotte, NC 28217. Call (704) 424-9780 or visit the Web site at www.bmhgroup.com.

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