Low Interest Loans To Family Members
Many years ago, high tax individuals used to lend money to spouses and children in order to generate investment income in the hands of lower rate family members. This included loans made directly to individuals and loans to family trusts. The Courts said, in many rulings that a loan is not a transfer. The income attribution rules were amended to include attribution on these loaned monies. If the loan proceeds were used to buy
property, say shares of a family company, the attribution rules would apply to have all dividends paid on the shares, and all capital gains realized on disposition of the shares taxed in the hands of the lender. But there is an important exception for loans made that charge interest at the prescribed rate for income tax purposes (currently 1%).
If a high rate taxpayer lends funds to a lower rate taxpayer, or to a family trust, AND interest is charged at the prescribed rate and actually paid, the income and any capital gains generated will be taxed in the hands of the borrower, not the lender.
BUT in order to avoid the attribution of income on the loaned funds and any property purchased with the loaned funds, the interest has to be payable, and actually be paid, no later than 30 days after the end of the taxation year. No matter how insignificant, this interest must be paid by January 30th, not January 31st, and a paper trail should be kept. Not only should paperwork be kept to show the payment, but the lender should be including the interest received in his or her tax return for the year of receipt of the interest. A lot of good, and expensive, tax planning could go out the window for the lack of paying two or three dollars of interest.
Once the loan is in place, the prescribed rate at the time of the loan will continue to be applicable to the outstanding balance of the loan.
It is important that all proper paperwork, including a promissory note to document the loan itself, must be prepared.