Archives for September 2020

How to Keep Family Loans Strictly Business

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Obtaining the funds to start or expand a small business doesn’t always come easy. If your family member can’t secure a loan from a commercial lender, you may be willing to help out by lending them the money yourself — but should you? Before handing over the cash, here are some best practices to consider:

Have a written agreement

Start by putting the loan agreement in writing. This may seem like an unnecessary formality, but without a written loan document, the IRS could argue that the transaction was a gift instead of a loan, potentially creating gift tax issues. Written documentation is also important if the borrower fails to repay all or part of the loan. In that situation, you want to be able to show you’re entitled to write off the unpaid amount as a non-business debt.

Charge adequate interest

The second step is setting an interest rate. While there’s no rule against interest-free loans or loans that have below-market interest rates, in a family context they can lead to tax complications. If you don’t charge sufficient interest, the difference between the amount of interest you actually receive (if any) and the amount you should have received — referred to as “imputed” interest — is taxable to you.

You can avoid the imputed interest rules by charging interest at the appropriate “applicable federal rate” (AFR). The IRS publishes AFRs monthly for loans of different maturities. These rates have been relatively low recently, reflecting the current market interest rate environment. For example, in November 2019, the annual AFR (using a monthly compounding assumption) was:

  • 1.68% for a short-term loan (three or fewer years)
  • 1.59% for a mid-term loan (more than three but no more than nine years)
  • 1.94% for a long-term loan (more than nine years)

For a term loan, the rate can remain fixed for the life of the loan. For a demand loan (one that gives you the right to demand full repayment at any time), you have to charge a floating AFR to avoid imputed interest issues.

What are the exceptions?

When you lend a family member no more than $100,000, the amount that can be added to your taxable interest income under the below-market interest rate rules generally can’t exceed the borrower’s net investment income. Even better, you won’t have to report any imputed interest if the borrower’s net investment income amounts to $1,000 or less. You can also side-step imputed interest on small loans of no more than $10,000, provided the borrowed funds aren’t used to buy or carry income-producing assets.

For more insight on family loans, and whether they’re a good idea for you, contact the NJ CPAs at Magone and Company at (973) 301-2300.

Employee vs. Independent Contractor — Why Worker Classification Matters

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Should a worker be treated as an employee or an independent contractor? There are legal differences between the two — and major tax distinctions as well.

 For an employee, a business must generally withhold income and FICA (Social Security and Medicare) taxes from the employee’s pay and remit those taxes to the government. In contrast, a business is not required to withhold income or FICA taxes for an independent contractor. The contractor is fully liable for his or her own self-employment taxes, and FICA and federal unemployment taxes do not apply. Generally, if a business has made payments of $600 or more to an independent contractor, it must file an information return (Form 1099-MISC) with the IRS and send a corresponding statement to the independent contractor.

Determining who’s who

Is a worker an independent contractor or an employee? The IRS examines factors in three categories:

  • Behavioral control — the extent to which the business controls how the work is done, whether through instructions, training or otherwise
  • Financial control — the extent to which the worker has the ability to control the economic aspects of the job. Factors considered include the worker’s investment and whether he or she may realize a profit or loss
  • Type of relationship — whether the worker’s services are essential to the business, the expected length of the relationship, and whether the business provides the worker with employee-type benefits, such as insurance, vacation pay, sick pay, etc.

When the proper classification is unclear, the business or the worker may obtain an official IRS determination by filing Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding.

Consequences of misclassification

When an employer misclassifies an employee as an independent contractor, the IRS may impose penalties for failure to deduct and withhold income and/or FICA taxes. Penalties may be doubled if the employer also failed to file a Form 1099-MISC, though the lower penalty will apply if the failure was due to reasonable cause and not willful neglect.

Employers with misclassified workers may be able to correct their mistakes through the IRS’s Voluntary Classification Settlement Program (VCSP). For employers that meet the program’s eligibility requirements, the VCSP provides the following benefits:

  • Workers improperly classified as independent contractors are treated as employees going forward
  • The employer pays 10% of the most recent tax year’s employment tax liability for the identified workers, determined under reduced rates (but no interest or penalties)
  • The government agrees not to raise the issue of the workers’ classification for prior years in an employment tax audit

Your tax advisor can help you sort through the IRS rules and fulfill your tax reporting obligations. Have questions? Reach out to the tax experts at Magone & Company today at (973) 301-2300.