TOPEKA, Kan. (RFD NEWS) — Farmers and ranchers often move substantial amounts of money among family members and business entities. But without proper documentation, the IRS may characterize those transactions differently than intended.
Roger McEowen with the Washburn School of Law joined us on Tuesday’s Market Day report to discuss what farmers can learn from a recent U.S. Tax Court case involving an art dealer, which highlights the potential tax consequences of relying on informal agreements when money changes hands.
A Handshake Deal Could Turn a Farm Loan Into Taxable Income
Tax Court Rejects $16.5 Million Loan Claim
In his interview with RFD News, McEowen explains the case involved an art dealer who received $16.5 million from another dealer for an art transaction.
The transaction eventually fell apart. The taxpayer later claimed the money was either a loan or a customer deposit. However, no written agreement existed when the money changed hands.
The taxpayer attempted to create a promissory note about five months later, after the transaction had gone bad.
The Tax Court determined the $16.5 million was taxable income, not a loan.
“The lesson for farmers is pretty simple: Don’t rely on a handshake,” McEowen said. “I know we like to do a lot of handshake deals in ag, but when substantial amounts of money are involved, don’t do that.”
McEowen said farmers should document the nature of a transaction when the money changes hands, whether it is a loan, investment, capital contribution or deposit.
What Makes a Bona Fide Loan?
McEowen said the Tax Court looks at the substance of a transaction rather than simply what the parties call it.
In determining whether a transaction is a bona fide loan, the court considers seven factors, including whether there was:
- A written note
- An interest charge
- A fixed repayment schedule
- Collateral
- Actual repayments
- A reasonable prospect of repayment
- Conduct by the parties showing they treated the transaction as a loan
“No single factor is decisive,” McEowen said. “But what they’re looking at is, when we take all those factors together, that’s going to tell the court whether there was a real obligation to repay when the money was originally transferred.”
Family Loans Need to Look Like Real Loans
Money transferred between family members can create additional questions, particularly when the parties do not charge interest.
McEowen said a family loan should be treated as an actual loan, including charging interest according to applicable IRS rules: “That means there’s going to be interest on that loan.”
The IRS publishes an applicable federal rate each month that can be used to establish an appropriate interest rate.
McEowen said families and friends may be tempted to set the interest rate very low, but doing so can create problems if the transaction does not look like a substantive loan.
Document the Transaction Before Transferring Money
McEowen said the first step is deciding what the transaction actually is before the money changes hands.
If it is a loan, he recommends preparing a formal loan agreement or promissory note identifying the lender and borrower, amount, interest rate, repayment schedule, and maturity date.
“Just like a bank would do,” McEowen said.
The parties also need to act like it is a loan by making payments, charging and paying the required interest, and keeping records.
If the transaction is an investment, capital contribution, or joint venture, McEowen said that relationship should also be documented.
“The bottom line here is, the tax character of the money is determined when the money changes hands,” he said. “Do all of this in advance, not when the IRS comes knocking.”
No Dollar Amount Guarantees Safety
McEowen said the need for documentation applies across the board, although the likelihood of an IRS audit can vary depending on the size of a transaction.
He noted that the $16.5 million transaction in the Tax Court case was substantial.
While a $10,000 transaction may be less likely to receive the same level of scrutiny, McEowen said farmers should still document the transaction properly.
MORE: When Money is Gross Income and Not a Loan - Firm to Farm
