Taxes: Familial Tax Savings

Good little tax breaks that work for anyone and everyone are hard to find. Or rather, it's hard to find such tax reduction methods that survive once a great number of people are taking advantage of them. I'm not talking about the medical deduction, or interest deduction, both of which are taken on Schedule A. They're nice—but after all, you do have to get sick, or go heavily into debt, to enjoy them.

No, I'm talking about goodies like the now-deceased commodities straddle, which converted gains and losses alike into taxpayers' moneymakers. It was outlawed by the Economic Recovery Act of 1981. Or the venerable vacation home "rental" property, where people would use their mountain cabin or seashore bungalow for about half the year, then rent the thing out the rest of the year but claim rental property deductions for the whole year. That one was wiped out back in 1976.

There is one, however, that the IRS has lobbied against, propagandized about, and litigated in court till they've gotten blue in the face. And the courts keep on siding with the taxpayers, slapping the tax-thieves right across the face.

The break? Interest-free loans. Here's how they work: Say you're slaving away and making pretty good money. Naturally, the harder you work and the more money you make, the more the government wants to take away from you; that is, the higher percentage they want to confiscate, which is fitting punishment, I'm sure we'll all agree, for working hard and being successful. On top of that, the tax system sees to it that the more money you save, the more you'll be penalized. After all, the more interest you earn by stashing money in banks and bonds and money market funds and so forth, the higher taxes you're going to pay as those extra dollars earned through interest push you into higher and higher tax brackets.

So what can you do? You don't want to give that money away. You're saving it for a purpose, such as survival. On the other hand, you do want the full benefit of those extra dollars working away for you, earning interest…if you can keep the tax-dogs off your back. Well then, try this: loan that extra stash out to someone you care for who isn't making so much money and thus isn't in such a high tax bracket as you.

This is usually done within a family—say, a father loans a bundle to his small, nonworking children. When they invest the money, the interest income is shifted to someone paying little or no taxes. But it can be done with anyone you care to benefit: friends, neighbors, lovers, et al.—just so you feel that you're being benefited as much by them making the interest as you would be. Thus, children and retired parents are favorites (you husband or wife won't work, since all the money made by both of you is lumped together for tax purposes).

In the meantime, when you're ready to take that money back and use it for something, you simply demand it back, since the loan is a "payback on demand" type, and everyone's happy except for the tax authorities.

This area, by the way, has been extensively litigated, usually with cases involving family-held corporations that loan out money interest-free to family members. The IRS reasons that since such a loan is interest-free, and the borrower would have had to pay interest if the loan was from any other source, then there must be invisible "income" in the form of that interest that doesn't have to be paid! They lose. Where taxpayers are careful to evidence a real loan, with a real intent and duty to pay back the principal, the courts have nowhere sided with the IRS in striking down such tax-saving methods.

Here's how is works: Say you've got a measly $15,000 in the bank or a money market fund earning interest. If it's getting only 12 percent, not even compounded, you'll be earning an extra $1,800 per year. If you're in the 40-percent bracket (making over $29,000 or so a year), then $720 is going to be taxed away, meaning you're really only getting $1,080 for your trouble. However, if you turn around and do up a demand-note with your child, parent, lover, subversive cohort, etc., (pick one) who isn't otherwise paying any taxes, the entire $1,800 goes to a good cause, tax-free. If you boost that $15,000 up to $50,000 or more, we're talking about some nice bucks (like several thousands saved from the tax hogs each year).

Now for the catches and caveats. In order to make this type of thing work, you cannot fool around. It's got to be a bona fide transaction, and a real loan, with a real promise to pay it back upon demand. You don't have to do up a formal writing, but it's an extremely good idea…just so everyone, including the IRS, knows where everyone else stands. Second, don't play around with the resulting interest and savings: it all belongs to the person who's borrowed the money, and you play games in this area at the risk of losing everything.

Third, watch out for the IRS coming in from way out in left field and saying that the statute of limitations has run in relation to your demand note and therefore the note can't be enforced, which means the thing turned into a "gift" when the statute ran, meaning you're going to have to pay a gift tax. This is a new tack the IRS has taken lately, because they couldn't win on any other theory. Solution: when the statute of limitations is about to run out, demand the money back, then do up a new agreement and a new demand note. Such statutes are different for each state, incidentally; in my home state of Florida the time-limitation is five years for a written instrument and four years for an oral contract/loan. So find out for yourself and play it safe.

Oh yes, if your accountant or tax specialist quails at the idea, tell him or her to look up, to mention just a few, Albert Suttle, 625 F.2d 1127 (4th Cir. 1980); Colin F. Beaton, 81-2 USTC par. 9789 (1st Cir. 1981); William G. Martin, 649 F.2d 1133 (5th Cir. 1981). Those are some major cases saying that such arrangements are quite okay.

So shift that money around! Lower incomes mean lower tax bites, and no one has a lower income than your six-year-old. Just make sure the little bugger signs on the dotted line.

Tim Condon is an attorney and a tax specialist practicing in Florida.