IRS Tax Rules for Family Loans

Family loans are a good way of advancing funds to your adult children or close relatives at little risk. The recession and mortgage crunch of 2007 really increased the scrutiny by banks on people borrowing funds. Though the bank rates are low, banks have become extremely conservative and have heightened their underwriting rules. For this reason, it may be hard for your children to get a loan from the bank for their education, car, to start a business, or any other expenses. However, you may be at a better position to qualify for a loan and therefore, take out a loan for your child. The IRS does not have any rules that punish taxpayers who advance their children a loan, as long as the loan is advanced at market interest rates. The IRS will only require the lender to report the interest earned and pay income taxes on the interest payments only. The IRS uses the Applicable Federal Rate (AFR) as the minimum interest rate to apply for family loans with no further tax consequences. Therefore, a parent can advance funds to a child at a level interest rate of the AFR at the time of lending.
Below Market Loan Rules
If a parent chooses to advance a significant amount to a child at zero interest or at a rate lower than the AFR, he or she will still have to pay a tax on the interest differential. In other words, the parent or lender will be charged a tax on the interest that he or she would have earned if the AFR was applied to the loan. Therefore, whether a lender applies the AFR, zero interest rate or a rate below the AFR, they will pay the same taxes since the IRS will consider the taxes that should have been paid if the loan was charged at the AFR rate. To avoid the complexities of adjusting for a below-market loan, it is advisable to just charge the Applicable Federal Rate.
Take Advantage of Prevailing Low Rates
The AFR rates have really come down, especially in 2010 and 2011. The low rates enable a parent, friend, or close relative to advance funds at very low and friendly interest rates without any tax implications. For example, in April 2011, the Applicable Federal Rate for short term loans with a duration of less than three years was 0.55%. The rate for mid term loans (between 3-9 years) was 2.46%, and the rate for long term loans (more than 9 years) was 4.17%. Therefore, if a parent advanced a child a house loan to be repaid in 20 years for example, the child will repay the loan at an interest rate of 4.17% for the whole duration of the loan, irrespective of whether the AFR rises or not.
Demand versus Term Loans
The rule of applying a level AFR for a given loan throughout the duration of the loan only pertains to a term loan. Term loans are loans that are advanced with clear terms set at the start of the loan; the loan is to be repaid at a specified time or in specified installments at set dates. If on the other hand, the loan is a demand loan, then the IRS will require the lender to keep changing the interest rate with changes in the AFR. A demand loan is a loan with no set rules and the lender can demand repayment at anytime. A demand loan therefore, cannot take maximum advantage of prevailing low rates, as the applicable interest for taxation will rise as the AFR rises.
Zero Interest Small Loans
The IRS applies the AFR and the below-market-loan rules on only significant loans that are above $10,000.00. For loans below this threshold, the IRS does not require the lender to charge interest. Therefore, the loan can be distributed interest-free without any tax implications. However, if interest is applied to the loan, the lender will report the actual interest earned as income and pay taxes on it.
 

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Tax Implications on Dependents

Children and other dependents can choose to either have their guardians or parents file a return on their behalf or file a tax return for themselves. However, there are various rules that apply to the taxation of dependents. Some of these rules are provided below:

• Claims on Personal Exemptions - In 2010, the personal exemption for all taxpayers was $3,650.00. However, dependents cannot claim personal exemptions on their tax return. Instead, their parents or guardian claim the exemptions on their tax returns on behalf of their dependents.
• Age Limit for Dependent - There is no age limit to being a dependent - there is no bottom or top limit. A child can file a return as a dependents as early as possible and people even beyond the age of 18 can continue to be dependents in qualifying circumstances.
• Earned Income Cap - If a dependent's income is only comprised of earned income, they are expected to file a return if the amount is more than $5,700.00. However, if they had withheld income and received W2 forms, it may be in their interest to file a return as they may be eligible for various tax breaks. Earned income includes income made from personal labor such as wages, salaries, tips, and fees and commission earned from services provided.
• Unearned Income Cap - Unearned income on the other hand, are incomes that are made without providing personal labor. This includes incomes such as dividends, capital gains, interest, and distribution from a trust. If a child or dependent received unearned income above $950.00, they are expected to file a tax return.
• Cap on Income Mix - If a child or dependent has both earned and unearned incomes, they will be expected to file a return if their total income is more than $950.00 or if their earned income is at least $5,400.00 and the unearned income is more than $300.00, whichever is higher.
• Circumstances that Dependent Must file return - There are circumstances in which a dependent is required to file a return, even if their income is below the aforementioned minimum incomes. These circumstances include when the dependent owes taxes for Social Security and Medicare. If the dependent receives any Earned Income Credit paid in advance, they will also file a return, regardless of one's incomes. Dependents who earn more than $108.00 from religious organizations that do not withhold Medicare and Social Security and dependents that make more than $400.00 from self employment are also required to file tax returns.
• Tax Credits for Dependents - A child or dependent can claim various tax credits, including Making Work Pay tax credit available in the 2011 tax year and education related tax credits and deductions.
• Standard Deductions for Dependents - Dependents who choose to file their own returns can claim standard tax deductions to whichever has the higher value: between $950.00 or earned income plus $300.00, to a cap of $5,700.00.
• Children's Tax Returns - Children can file their own tax returns. However, any penalties and audits will be addressed to the child. If the child is very young, the IRS expects that the guardian provides his or her signature next to that of the child and indicate that they are the parent or guardian. This way, in case of any recourse, the parent can take responsibility. When children file their own taxes, they get an early start to knowing about taxation and personal financing.

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Accuracy Rates Declining at Volunteer Tax Prep Sites

Accuracy Rates Declining at Volunteer Tax Prep Sites

Incomes Not Subject to Federal Income Tax

Federal income tax is levied on almost all incomes received by every taxpayer. All incomes are to be reported on one's tax return form and the applicable tax rate is applied on the total amount of income to determine the taxes due. However, there are certain income types that are not subject to Federal Income taxation. Some of these incomes are:
Distributions from a Roth IRA
A Roth IRA is a retirement fund in which contributions are taxed at the applicable income tax rate, but the withdrawals from the fund are tax free. In other words, the contributions to a Roth IRA are done after taxation. However, proceeds after retirement are tax-free, irrespective of the amount. This is in contrast to traditional IRA accounts, where the contributions to the retirement funds are tax deductible, but the proceeds from the fund are taxed.
Child Support
Payments for child support are not taxed on both ends. In other words, the person providing the child support is not taxed and the guardian of the child or children receiving the child support is also not taxed. No tax reporting is necessary for the child support funds. This is in contrast to alimony payments, where the person receiving the alimony has to pay Federal Income Taxes on the amount.
Death Benefit of an Insurance Policy
Most life insurance policies are tax-free for the death benefit. This means that no Federal Income Tax is applied on the proceeds of the life insurance policy. Death benefit proceeds from health insurance policies, accident insurance policies, and endowment life insurance policies are also income-tax free. However, the beneficiaries of the death benefit may pay an Estate Tax if the amount of the proceeds qualifies.
Gifts
Cash and other gifts with a monetary value are also not subject to taxes. Therefore, if you receive a gift from a friend or relative, you are not required to disclose the gift or pay taxes on the gift. However, the person providing the gift may be liable for a Gift Tax. From tax year 2010, every taxpayer has a gift cap of $5,000,000.00 for his or her whole lifetime (that he or she can give away tax free). Beyond this cap, the taxpayer is expected to pay a Gift Tax for gifts given if the value of the gifts to a specific individual exceeds $13,000.00 per year.
Return on Capital
Any investments you put into a fund or any other investment vehicle is not subject to taxes on withdrawal. The only amounts that are taxable are the growth on the investment (capital gains) and any interests or dividends from the investment. The withdrawal from the investment is called "return on capital."
Federal Tax Refund Check
Federal tax refunds are not subject to Federal Income Tax. Therefore, if you get to receive a refund check from the IRS, you will not pay taxes or report it as an income in the subsequent tax year's returns. However, state tax refunds are subject to Federal Income Taxes. When you receive a state tax refund check, you are provided with a Form 1099-G and are expected to report the refund as income for the next year's tax return.

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Extra Scrutiny Delays Refunds for Adoption Credits

Families that adopt children incur a lot of costs in the complicated processes of adoption. However, the government does provide some help with these costs. Taxpayers can claim a tax credit against the costs of adopting children. Better still, some changes made to this credit in 2010 make the credit even more favorable to those who adopt children.
2010 Changes to the Adoption Credit
Prior to the 2010 tax year, the adoption credit was a traditional tax credit. This means that the taxpayers could only apply the credit against their existing tax liabilities. If the amount of the credit exceeded the taxed that owed, the taxpayer's remaining credit balance would carry forward to the next 5 tax years or until the credit was exhausted, whichever came first. The maximum amount of the tax credit you would be able to claim on an adopted child was $12,150.00 for the 2009 tax year. However, the tax law adjusted the rules of the adoption credit to make it more favorable for parents who had adopted children. From tax year 2010, the credit was adjusted from a traditional credit to a refundable credit. This means that taxpayers claiming the credit can now receive a refund check for any outstanding credit that is not used up by other tax liabilities. In other words, a taxpayer with no tax liability can cash the credit on the same year that he or she makes a claim. Better still, a taxpayer can receive a refund check for any credit that remained outstanding over the previous 5 years. The 2010 adoption credit cap was also raised to $13,170.00 per child.
Figures Pertaining to the Adoption Credit for Tax Year 2010
The changes to the adoption credit have meant that taxpayers who have adopted children and who have outstanding unclaimed expenses can now claim huge refund checks from the IRS. Parents with multiple adoptions can make claims for each child. This has led to high credit claims for the tax year 2010. According to the Treasury Inspector General for Tax Administration (TIGTA), there were 72,656 taxpayers who had made claim to this credit. The value of the credit being claimed was $897 million in total. This means that on average, a taxpayer with an adoption credit claim will receive a refund check of over $12,000.00.
Erroneous Claims
Taxpayers claiming the adoption credit for 2010 were required to file a paper tax return. They were also expected to file Form 8839 detailing the expenses relating to the adoption being claimed. They were also required to attach support documentation for every expense claimed pertaining to the adoption. However, according to the IRS, many of the taxpayers with a claim either missed including the support documentation or erroneously claimed the credit. TIGTA reported that as of March 4, 10,000 returns had been received with the adoption credit claim and about 7,000 of them (70%) either had insufficient documentation or submitted the claim erroneously.
Delays in Refunds
Due to the excessive errors in the adoption credit claims, the IRS is applying extra precaution on these returns, which has slowed down the process of reviewing and distributing the refund checks. As of June 2010, a majority of those expecting a refund check from the credit had yet to receive it. However, though the parents awaiting the checks must be frustrated, taxpayers should be glad that extra scrutiny is being applied. Otherwise, lots of taxpayers' funds could have been lost through erroneous claims.

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IRS Gives One-Week Filing Extension to Taxpayers Whose Preparers Were Affected by Hurricane Irene

WASHINGTON — The Internal Revenue Service today announced it is granting taxpayers whose preparers were affected by Hurricane Irene until Sept. 22 to file returns normally due Sept. 15. The taxpayer’s preparer must be located in an area that was under an evacuation order or a severe weather warning because of Hurricane Irene, even if the preparer is located outside of the federally declared disaster areas.
This relief, which primarily applies to corporations, partnerships and trusts that previously obtained a tax filing extension, is available to taxpayers regardless of their location.
This relief does not apply to any tax payment requirements.
This relief is in addition to the filing and payment relief the IRS is providing to taxpayers located in disaster areas declared by the Federal Emergency Management Agency (FEMA). For details, visit Tax Relief in Disaster Situations on the IRS website, www.irs.gov.

Owe the IRS, but can’t pay? An Offer in Compromise may be the answer.

 If you are unable to pay your tax liability in a lump sum or through an installment agreement and you have exhausted your search for other payment arrangements, you may be a candidate for an Offer in Compromise.
 
What is an Offer in Compromise?
An OIC is an agreement between a taxpayer and the IRS that settles the taxpayer’s tax liabilities for less than the full amount owed. The IRS has the authority to settle, or "compromise," federal tax liabilities by accepting less than full payment under certain circumstances. Absent special circumstances, an offer will not be accepted if the IRS believes the liability can be paid in full as a lump sum or through an installment agreement.
In most cases, the IRS will not accept an OIC unless the amount offered by the taxpayer is equal to or greater than the reasonable collection potential (RCP). The RCP is how the IRS measures the taxpayer’s ability to pay and includes the value that can be obtained from assets such as real property, automobiles, bank accounts and other property. The RCP also includes anticipated future income, less the amounts allowed for basic living expenses.
You should beware of promoters’ claims that tax debts can be settled through the OIC program for "pennies on the dollar." Some promoters are inappropriately advising indebted taxpayers to file an OIC application with the IRS. This bad advice costs you money and time.
 
Do I Qualify for an Offer in Compromise?
Not all taxpayers qualify for an OIC. Absent special circumstances, if you have the ability to fully pay your tax liability in a lump sum or via an installment agreement, an OIC will not be accepted.
In order for your OIC to be considered, you must meet the following requirements:
1. You are not a debtor in an open bankruptcy proceeding. must pay $150 application fee with your offer.*
2. must submit one of the following payments with the offer:
   o Option 1: 20 percent payment of the offer amount
   o Option 2: the first monthly payment
*You may be exempt from the $150 OIC fee depending on income or whether the OIC is based solely on doubt as to tax liability. Taxpayers who claim the poverty guideline exception must certify their eligibility using Form 656-A, Income Certification for Offer in Compromise Application Fee. The poverty guideline exception applies only to individuals.
 
How do I File an Offer in Compromise?
The Form 656-B, Offer in Compromise Booklet contains information about filing an OIC and all forms necessary to file an one. When submitting an OIC, you must use the most current version of Form 656, Offer in Compromise, or Form 656-L, Offer in Compromise (Doubt as to Liability), depending on the basis of the OIC. The objective of the OIC program is to accept an OIC when it is in the best interest of both you and the government and promotes voluntary compliance with all future payment and filing requirements.

We can help you with these and any other problems you may be having with IRS. As an Enrolled Agent, we can represent you before the IRS.  Give us a call at 865-984-6329.

IRS Provides Tax Relief to Victims of Hurricane Irene 

WASHINGTON –– The Internal Revenue Service is providing tax relief to individual and business taxpayers impacted by Hurricane Irene.

The IRS announced today that certain taxpayers in North Carolina, New Jersey, New York and Puerto Rico will receive tax relief, and other locations are expected to be added in coming days following additional damage assessments by the Federal Emergency Management Agency (FEMA).
The tax relief postpones certain tax filing and payment deadlines to Oct. 31, 2011. It includes corporations and businesses that previously obtained an extension until Sept. 15, 2011, to file their 2010 returns and individuals and businesses that received a similar extension until Oct. 17. It also includes the estimated tax payment for the third quarter of 2011, which would normally be due Sept. 15.
Full details, including the start date for the relief in various locations and information on how to claim a disaster loss by amending a prior-year tax return, can be found in tax relief announcements for individual states on this website.
The tax relief is part of a coordinated federal response to the damage caused by the hurricane and is based on local damage assessments by FEMA. For information on disaster recovery, individuals should visit disasterassistance.gov.
Tax Relief Available So Far
Filing and payment relief is currently available to taxpayers in federal disaster areas declared in North Carolina, New Jersey, New York State and Puerto Rico. The IRS expects to announce tax relief for taxpayers in other areas as damage assessments continue. The IRS encourages taxpayers and tax practitioners to monitor Tax Relief in Disaster Situations on this website for updates.
So far, IRS filing and payment relief applies to the following counties and municipalities:

• In North Carolina: Beaufort, Carteret, Craven, Dare, Hyde, Pamlico and Tyrell;
• In New Jersey: Bergen, Essex, Morris, Passaic and Somerset;
• In New York: Albany, Delaware, Dutchess, Essex, Greene, Schenectady, Schoharie and Ulster; and
• In Puerto Rico: Caguas, Canovanas, Carolina, Cayey, Loiza, Luquillo and San Juan.