Q. My daughter, a stay-at-home mom, is going through a rough and rather lengthy divorce, and I’d like to help her cover some of her legal fees. I know I can gift up to $14,000 and not file a gift tax, but unfortunately she will need much more than that amount of money. I was thinking about setting it up as a loan and then forgiving the loan once this is all settled. At the very least, I certainly would not charge her any interest. Do you see any problem with this approach?
A. I’m sorry to hear of your daughter’s divorce. Not a fun time for anyone. If you decide to make a loan, from a financial viewpoint, it should be set up as a true loan, carry an interest rate and documented with paperwork. The IRS doesn’t like inter-family no-interest loans. If you don’t charge interest, you will have imputed interest and be taxed on the difference between the IRS Applicable Federal Rate (AFR) and the interest rate actually charged. If your daughter doesn’t make any interest payments, the amount she should have made using the AFR will be deemed a gift by you. I would properly document the loan and charge the AFR or a slightly higher rate. The annual AFR for loans made in October 2014 are: 0.36 percent for loans with a term of less than three years, 1.86 percent for loans with a term of three to nine years and 2.97 percent for longer-term loans.
For a legal viewpoint, I contacted an attorney friend of mine, Sonya DuBree, manger, Raleigh Family Law PLLC, and she put me in contact with one of her associate attorneys, Imogen J. Baxter. Imogen was kind enough to take the time and provide the following:
Here are my thoughts on the family law aspects of this issue:
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1. A lawsuit involving custody, child support, spousal support, and property distribution can be a financial hardship for anyone, especially someone that is considered a “dependent spouse.” A dependent spouse, in North Carolina, is defined as a spouse, husband or wife, who is actually substantially dependent upon the other spouse for his or her maintenance and support or is substantially in need of maintenance and support from the other spouse.
2. Oftentimes family members step in to provide financial assistance to a party who is a dependent spouse and would not otherwise be able to meet the other party on a level playing field in litigation. In this case, as a stay-at-home mom during the marriage, your daughter is likely considered a dependent spouse for purposes of spousal support.
3. When providing financial assistance to a family member in this situation, or perhaps being on the receiving end of such assistance, it is important to make sure this assistance will not have a detrimental impact on the party’s spousal support case in litigation.
4. The courts know that financial assistance from a family member, or even a close friend, is one where the lender will more often than not be less strict on a timeline for repayment, or repayment at all, than a traditional lender. An opposing party will often argue that this financial assistance, even if called a loan, should be counted as income to the receiving party and/or not considered a real debt when calculating spousal support.
5. If you intend to treat the financial assistance as a true loan, in other words, you are expecting repayment, the best practice is to memorialize the terms of the loan in writing.
6. This can be done in several ways. The most common is preparing a Promissory Note with the terms of the loan, including any interest rate if applicable, and the repayment schedule. Not only does this help “legitimize” the loan in the eyes of the Court, but this sets forth your expectations as a lender at the outset and can help avoid conflicting understandings of the terms amongst yourselves and in the event your testimony is required in Court.
7. Your daughter should begin making payments on the loan, however small, once she is able to do so.
8. Contact an attorney should you wish to explore this issue further, and obtain assistance in memorializing this type of loan.
Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 97128, Raleigh, NC 27624.