Final answer:
For loans between related parties to be deductible, they must be formalized with proper documentation, charge a reasonable interest rate, have provided collateral, and show attempts at collection if defaulted. These requirements align with standard practices in the financial capital market, where banks mandate similar criteria to ensure the validity and recoverability of a loan.
Step-by-step explanation:
When loans are made between related parties, such as family members or affiliated businesses, certain criteria must be met for the Internal Revenue Service (IRS) to recognize the transaction as a legitimate loan rather than as a gift, which could have different tax implications. Those criteria generally include: the loan being properly executed with a formal agreement, charging a reasonable rate of interest, securing the loan with collateral, and evidence of collection efforts should the borrower fail to repay according to the terms.
In the financial capital market, similar principles apply. Banks require a formal application process, a credit check, and often additional layers of security such as a cosigner or collateral. Collateral serves the same purpose for banks as for related parties: it provides a means to recoup the lent resources in case the borrower defaults.
Therefore, to be considered a legitimate debt arrangement for the purposes of deductibility, related party loans should adhere to structured lending practices similar to what a financial institution would require.