GIVING THE GIFT OF A LOAN
Intra-family loans can provide tax benefits to both lenders and borrowers if properly structured.
JOHN O. McMANUS
JOHN O. McMANUS is a top AV-rated estate planning attorney and the founding principal of TriState Area-based McManus & Associates (www.mcmanuslegal.com).
When it comes to wealth management, sometimes the gray area is the sweet spot. There are often legitimate opportunities for growing and preserving assets beyond the welldefined, black-and-white tax rules. Identifying these legal loopholes can greatly benefit a client and his or her loved ones, without breaking any laws.
Gifting as a loan, or intra-family loans, is an estate planning technique which, under rules set forth in the Code, allows a significant amount of money to be transferred to a family member with a customized repayment plan—sans the gift tax implications. Also, there are no concrete limitations on the family members who can be borrowers or the trusts for their benefit. With carefully structured lending— through a promissory note, for example—the borrower is able to take advantage of interest rates below those charged by commercial lenders, as the government allows relatives to pay a very low, “safe harbor” interest rate. In a parent-child relationship, the child then pays back the loan over time.
Intra-family loans can be a winwin for all involved in the arrangement. Borrowers get a loan when they otherwise may have been unable to do so due to weak credit history, self-employment, uneven income, or disability, and lenders earn a significantly higher percentage of interest income than they would have been able to gain with other instruments, such as a five-year certificate of deposit. In addition to interest payments being kept in the family rather than being paid to outside banks, intra-family loans sidestep significant closing costs and other expenses that are often requisite with borrowing from outside lenders.
To boot, there is a valuable opportunity for an estate tax and income tax-free transfer of wealth to the younger generation. If the asset that the borrowing family member acquires with the loan proceeds has combined income and appreciation greater than the interest rate that is paid on the note, equity in the assets accrues for the benefit of the borrower and that wealth would not be subject to estate tax as a part of the parents’ estates.
A hypothetical case study clearly paints this wealth transfer picture. Consider a parent who loans $1 million to a child in October 2016 with a nine-year balloon note bearing interest at 1.29% compounded annually, the Applicable Federal Rate (AFR) in October 2016 for midterm notes. If the child receives a 6% combined growth and income annually on the asset acquired with the loan, the net transfer to the child would be $567,204, free of gift tax. How does the math work?
• Amount the child owns at the end of the loan: $1 million at 6% compounded annually for nine years = $1,689,479.
• Amount owed by the child at the end of the loan: 1.29% interest on $1 million compounded annually for nine years = $1,122,275. • Amount the child owns ($1,689,479) minus the amount the child owes ($1,122,275) = net transfer to the child ($567,204).
Of note, in order to achieve the maximum income tax benefits, many intra-family loans are made to grantor trusts, which are trusts where the grantor (the parent in the prior example) is treated as the income tax owner. This ensures that, if the parent is selling an asset to the trust in exchange for a promissory note, the sale would not create a capital gains tax. Additionally, the interest paid by the borrower-child to the lender-parent would normally be reported by the parent as ordinary income, but this would not be the case when a grantor trust is the borrower. Finally, if the grantor-parent is the income tax owner of the asset held in the grantor trust, any taxes resulting from the growth of or income generated by the assets are reported and paid for by the grantor-parent, which allows the assets of the trust to appreciate at a more rapid rate, because they will not suffer the natural drag and depletion from paying income taxes.
The IRS takes care to ensure that intra-family loans are more than just camouflaged gifts, and its scrutiny of the issue can lead to the imposition of significant gift tax that could otherwise have been avoided. Individuals can take advantage of the annual gift tax exclusion and give multiple gifts of $14,000 (doubled to $28,000 for joint gifts made by a married couple) per year or less to an unlimited number of different people and organizations, without filing a gift tax return. Gifts of larger amounts are taxable and need to be reported on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return. The tax can be offset by using the combined unified gift and estate tax exemption—$5.45 million for 2016—with any federal tax assessed on lifetime gifts subtracted from the combined unified gift and estate tax exemption after death. For those who do not want to dip into the $5.45 million exemption to preserve it for future wealth transfers during their lifetime or on death, or for those who have already reached the ceiling of the lifetime gift tax exemption, structuring the transaction as a loan can help avoid filling Uncle Sam’s coffers.
Putting in the time and effort to seek professional guidance and follow it can save more than just pocket change. Formalities must be followed to eliminate any doubt and prove to the IRS that the loan was made in good faith. In fact, there are several important steps that should be taken before the money is disbursed, as well as follow-up items that must be addressed throughout the course of repayment to ensure that the loan is considered legitimate.
First and foremost, verify that the borrower is capable of repaying the loan. If the IRS determines that a family member was lent money despite being unable to pay off the debt, proving that there was a reasonable expectation for repayment becomes very challenging.
Next, the family member lending the money should make the family member borrowing the money sign a promissory note. This is the most important piece of the puzzle in proving the transaction was structured as a loan and not a gift. Have a document drafted that outlines the loan’s interest rate, due date, and any payment schedule.
Collateral should be requested from the borrower, as well. While it may seem strange for the lender family member to ask for a security interest in the borrowing family member’s small business or to require safekeeping of that collectible classic car, banks will not lend money without first demanding collateral from the borrower. Thus, in order for a loan to pass the test as a business transaction, the family member putting up the money should require that the borrower put up some form of pledged asset, whether security interest in the borrower’s residence, business assets, or valuable personal property.
Charging interest on the loan at or above the minimum “safe harbor” rate is another key factor in structuring the transaction, so it is not dismissed by the IRS as a gift masquerading as a loan. The safe harbor rate (or the AFR, as with the hypothetical scenario above) is very low by commercial standards and is published monthly by the IRS. Take note: If an interest rate below the AFR is used when structuring the intra-family loan, the lender’s generosity will often be met with two federal tax consequences: (1) The lender is treated as having made a gift to the borrower of the difference between the AFR and the interest rate actually charged (imputed interest), and (2) The borrower is deemed to have paid that imputed interest to the lender, which must be reported on the lender’s income tax return. Furthermore, case law shows that claiming ignorance will not hold up as a defense in court, so check and double-check the proper rate to charge on the loan. For easy calculations, use a term loan and a fixed rate so that the interest is not adjustable.
To reinforce that the money that has been doled out to the borrower is a loan and not just a gift, create and implement a fixed repayment schedule. This demonstrates that the lender actually expects to receive timely payments, as would be the case with a bank loan. Hand-in-hand with establishing a repayment schedule, insist on repayment from the borrowing party. Lending money to a family member and allowing his or her payment due dates to come and go without ordering repayment communicates that the lender is not serious about carrying out the terms of the loan, raising a red flag for the IRS. The loan will be treated like a “gift,” and the effort to help will soon hurt.
In addition to the lender making efforts to claim what is owed, both parties should keep detailed records on the loan. The regular payments made in pursuit of paying off the loan should be marked in the books. For an added layer of security, document each payment with correspondence—the lender should send a receipt or note in reply to each payment. “Put it in writing” goes for communication with the IRS, as well. A loan is defined as a sum of money that is expected to be paid back with interest. Thus, the family member lending the cash must acknowledge the interest income on his or her tax returns for the intrafamily loan to pass muster (unless, as described above, the loan is made to a grantor trust).
These are the many “do’s” when making an intra-family loan, but there are also many “do not’s” that should be avoided for the sake of a successful arrangement. For instance, do not etch out a plan in writing to forgive missed payments, which would hint that the financial obligation was a sham. Making a loan to a family member and forgiving payments on the note when they come due is often used as a vehicle for the annual exclusion of gifts to family members—but it is a method that rests on a bed of sand. There is a history of the IRS confronting this strategy in court. While application of the annual exclusion has been allowed in some cases, forgiven payments have been pointed to as strong evidence that the lender never expected repayment in others. Bottom-line: Steer clear of anything that would suggest that there was a planned agreement to forgive the debt in order to skip out on payment of gift tax.
Another major “do not” is letting family dynamics cloud the business arrangement. The lender should dot the i’s and cross the t’s, rather than relaxing requirements for a relative. If insisting on collateral or demanding repayment from a family member is too uncomfortable, an intrafamily loan may not be a safe option. Clear communication at the outset regarding expectations should help avoid any unwanted surprises.
If gifting as a loan with multiple family members, be consistent with requirements to keep family members happy and conduct good business in the eyes of the IRS. While the amount need not be the same for the various loans, family discord may arise if borrowers feel like the lender is playing favorites, with a more favorable interest rate for one relative than another. Additionally, inconsistency might suggest favoritism from the outside looking in, which is uncharacteristic of a bank loan and could discredit a loan’s authenticity, according to the government.
The safest way to forgive an intra-family loan is to have the borrower consistently pay back the lender the amount owed as mapped out, but to also have the lender make gifts back to the borrower annually, subject to the annual and lifetime gifting limitations. The transactions should be spaced by time and handled separately so that they are not lumped together as a “step transaction.” While it is not an exact science, the accepted waiting period is typically thought to be one-to-three months between steps.
Whether it is to help a loved one get a start in life, build a business, or buy a place of his or her own, consider giving the gift of a loan. If properly established, managed, and documented, intra-family loans can benefit the lender and the borrower. Finding this sweet spot takes foresight, expert knowledge, and organization—because no good deed goes unpunished, unless you have good planning.
INTRA-FAMILY LOANS: GIVING THE GIFT OF A LOAN, John O. McManus, Practical Tax Strategies and Volume 98/Issue 2, Copyright 2017, Thomson Reuters/Tax & Accounting.