Sarah and her sister Sylvia are quite different. Sarah settled down quickly after college to start a family and a career. Sylvia spent years traveling the world.

For various reasons, Sylvia decided it was time to cease her travels and put down roots. The problem: She was deeply in debt. Sarah wanted to help her but was concerned about the tax implications of a loan. She visited her financial adviser for help.

Her adviser began by explaining that, for tax purposes, the key distinction to draw regarding any would-be loan is whether it would, in fact, be a loan. Many so-called "intrafamily" loans turn out to be gifts, because the lender never demands or receives full payment. If the Internal Revenue Service concludes that the transaction isn't a bona fide loan, it will recharacterize it as a taxable gift.

Defining factors

Sarah's adviser explained that, if the IRS or a court ever were to decide to determine whether Sarah lent Sylvia the money or just gave it to her, they'd assess a variety of factors. These would include whether there was a written agreement, whether Sylvia executed a promissory note, and whether there was a fixed repayment schedule according to which Sylvia actually made payments.

Not all of these factors must be present, but the more, the better Sarah's chances of the loan withstanding scrutiny. And regardless of how well Sarah planned the loan, the IRS might still recharacterize the loan as a gift if it determined that the loan's sole purpose was to avoid taxes.

Charging interest

Sarah's adviser went on to explain that another key factor in establishing the validity is whether she charges adequate interest. A loan would be considered below market if she were to charge less than a minimum interest rate, determined by the applicable federal rate. Then, the IRS could "impute" interest, resulting in both a taxable gift as well as income tax consequences.

The federal government sets the AFR monthly, and the rate varies depending on the type and term of the loan. Intrafamily loans generally fall into two categories:

1. Demand loans. These are payable on demand or have an indefinite maturity. The minimum rate for a demand loan is the short-term AFR, compounded semiannually. With a demand loan, the minimum rate varies during the life of the loan. So the easiest way to ensure that you charge enough interest is to use a variable rate that's tied to the AFR.

2. Term loans. Here the transaction more closely mirrors a conventional bank loan, having a stated payment due date and a definite maturity. These use the AFR that's in effect on the loan date. The rate will differ, depending on whether the loan is short term (less than three years), midterm (three to nine years), or long term (nine or longer).

Sarah's adviser made clear that, even if bona fide, both demand loans and term loans have income tax consequences. Generally, interest received will be taxable and interest paid may or may not be deductible, depending on what the loan was used for.

Lending prudently

In Sarah's case, by formalizing the transaction and treating it as a loan, she was able to avoid any unforeseeable negative tax consequences. In the end, she didn't regret lending her sister the money -- because by discussing it with her financial adviser first, she understood everything going in.

This has been a general discussion and is not intended as advice. Always discuss your particular situation with your financial adviser before taking any action.

Norm Grill is the managing partner of Grill & Partners LLC, certified public accountants and consultants to closely held companies and high-net-worth individuals, with offices in Fairfield and Greenwich. He can be reached at 203-254-3880 or N.Grill@GRILL1.com.