What is a “gift” according to the IRS?

Sometimes friends and family want to loan money without expecting the entire amount back. The IRS typically views this sort of transaction as a gift and could impose a hefty gift tax on the giver. The gift tax applies if someone gives money or something of value (i.e. cash, real property, equipment, etc.) to someone else and the giver receives nothing or less than full value in return.

The gift tax may apply whether the giver intends the money to be a gift or not. The definition of a gift includes any transaction where less than full value is paid in return, so the gift tax could be applied to interest-free loans from friends and family. That’s because the “market rate” of lending money comes with a cost in the form of interest charges. So while it may be tempting to charge a friend or family member no interest or even less interest than a loan from a bank would, the IRS will pretty much always deem interest-free loans as a gift subject to the gift tax. The best way to avoid this is to have a written promissory note in place and for the lender to charge the minimum IRS-set interest rate. As of December 2015, this rate is 2.61%.

Exclusions to the gift tax: when does the gift tax really matter?

Note that there are some key exclusions to the gift tax. First, each person can give away up to $14,000 a year (as of 2015) to as many people as he or she wants. Note that the giver-receiver relationship is each considered separate. So let’s say there’s a husband and a wife who have two kids. The husband could give each of the kids up to $14,000 each year without being subject to the gift tax. The wife could do the same. So each kid could get up to $28,000 a year from his or her parents without either of the parents having to pay a gift tax.

Also, each person has a lifetime exemption from the gift tax, which is currently $5.43 million. This is the total amount that can be given away by an individual over his or her entire lifetime to any number of people that will be free from gift taxes. Until this amount is exhausted, the giver will not be required to pay a gift tax. So let’s say that the husband gives his kids each $20,000 in a given year. This amount is above the $14,000 mark and is therefore subject to the gift tax, but the husband still won’t owe a gift tax unless he’s exceeded his $5.43 million lifetime amount. Note, however, that any amount gifted will reduce the amount that can be given away by the individual at death that will be free from estate taxes. In effect, the lifetime gift tax exemption is directly tied to the federal estate tax exemption.

The takeaway is that the gift tax is for the most part an issue for individuals with quite a bit of money or who expect to have a lot of money to bequeath at the end of their life. This may or may not be an issue for the lender in your situation.

Keeping records of gifts or loans could impact the farm operation’s taxes

Either way, it’s important for the farmer to properly account for the money as it comes in. Is it a gift or is it a loan? If it’s a gift, the amount would be placed on the asset side of the farm operation’s balance sheet. If it’s a loan, the amount would be placed on the liability side. If the person lending the money thinks it is a loan but you have not accounted for it as such, then it may cause issues for them down the road with the IRS. No one wants to be audited. In addition, whether you account for the money you receive as a loan (debt) or as a gift (asset) could have an impact on the amount of federal and state taxes your farm operation will owe in a given year. Having a promissory note in place that includes interest charges provides evidence that it is, in fact, a loan that is accounted for as debt to the farm operation and not a gift that is accounted for as assets.