Criteria for commercial loan so that interest is deductible?

Question

A family member wants to lend me money for a business venture. I want to be able to deduct the interest I pay him as a business operating expense. However, I understand that the IRS is often skeptical of the deductibility of loans between family members. I want to structure the loan so they are maximally convinced.

For this purpose, I propose that:

• the promissory note specifies the business purpose of the loan
• the interest be charged at 4% compounded monthly, with late fees if I am late on a payment
• the funds be deposited in a business account, used only for business purposes

What else might I do to keep the IRS certain this is in fact a commercial loan, so that I can be sure the interest is deductible? In particular, how does the IRS consider term, amortization, and interest rate when determining whether it is a bona fide commercial loan?

Any general discussion or links to relevant IRS documentation is appreciated. I've poked around on irs.gov, but I can't find anything useful.

Answer 1

You can hire a good CPA for a really low price. They can advise you on how to do exactly what you said and many other aspects of your business. Mine does this as a courtesy with the filing of my taxes. And the filing of my taxes is not all that much. It is great value for the money.

Recently I had to make a decision that is a potential audit situation and can go badly if not properly documented. It was not hard to document (with the CPA's help), but now that it is so I don't lose mental energy on if I am going to get "caught" by the IRS. Let them come, I have the necessary documentation.

Beyond the IRS, I really like the documentation that you are trying to put behind this loan. Having this in writing helps smooth this potentially bad situation between you and the BIL. I would go above and beyond writing conditions and contingencies down in order to keep this relationship happy. With these kinds of things, cover the applicable 5 "Ds" of partnership agreements:

• Divorce: what happens if you have to split the business, or he the loan
• Drugs: What happens if someone does something illegal
• Disinterest: What happens if you become uninterested in running the business or he needs the cash.
• Death: What happens if you or he dies?
• Disagreement: Probably does not apply, you are not giving him an ownership stake with decision making.

However, I would add another: Boom. What happens if your business takes off? Perhaps there should be a clause to retire the loan prior to you expanding beyond a certain level.

Please understand I am not suggesting that any of these bad things are going to happen to you (except the Boom, I really hope that happens to you), but it is a way to communicate contingent actions if one of the risks of small business materializes. Having agreements ahead of time helps avoid crisis.

Answer 2

Writing a promissory note will be sufficient. Presumably the money will be transferred on or near the date that the loan is signed, and the repayments will follow the pattern prescribed in the note. The IRS is only skeptical of family loans if there is no documentation to support the claim.