Advice For Family Loan / IRS

1. Do You Need to Pay Interest?

Yes, in most cases: For loans over $10,000, the IRS expects a minimum level of interest to be charged, known as the Applicable Federal Rate (AFR). If no interest is charged, the IRS may treat the “foregone interest” as a gift, subject to gift tax rules.
Short-term exemption: Since your loan will be repaid on January 4, 2025, and the loan term is extremely short, it may fall under de minimis rules. Loans with a very short repayment period (a few weeks) are generally less scrutinized for interest if they don't result in significant tax avoidance.

2. What Documentation Do You Need?

To avoid any disputes with the IRS, it's a good idea to create formal documentation for the loan. Here’s what you should do:

Write a Promissory Note:
- Include the loan amount ($40,000).
- Specify repayment terms (date and amount, e.g., January 4, 2025, $40,000).
- Mention whether interest is being charged. If interest is included, use the AFR for short-term loans, available on the IRS website for December 2024.
Sign and Date the Agreement:
- Both you and your family member should sign and date the agreement.
Retain Copies: Keep copies of the promissory note and proof of repayment for your records in case of an audit.

3. What Happens If You Don’t Charge Interest?

If you do not charge interest, the IRS could treat the “foregone interest” as a gift. For example:

At the current AFR (let's estimate 4% annually for simplicity), the “interest” for a 5-day loan would be around $22.
Since the gift amount is below the annual exclusion limit ($18,000 for 2024), this is unlikely to trigger gift tax implications, but documenting it as a loan still provides clarity.

4. Are You Avoiding Tax?

If the loan was structured to keep your income below a threshold to qualify for a tax benefit or financial aid, the IRS may scrutinize the transaction if audited. Ensuring the loan is properly documented as legitimate (with clear intent to repay) helps avoid issues.

5. Steps to Take:

Draft a promissory note with repayment details.
Use the short-term AFR for December 2024 if adding interest.
Repay the loan on January 4, 2025, and keep documentation of repayment.
If no interest is charged, be prepared to explain the short repayment period if audited.