Interest rates remain extremely low, enhancing the benefits of intrafamily loans. These loans allow you to provide financial assistance to loved ones — often at favorable terms — while potentially reducing gift and estate taxes. But what about families that lack the liquid assets to make such loans? Are there other options?
One lesser-known possibility is for trust beneficiaries to borrow money from a trust. This strategy requires careful planning, however, because the trustee must consider his or her fiduciary duty to the trust and its other beneficiaries in approving and structuring such a loan.
An intrafamily loan can be a great way to help out your children or other family members financially while also transferring significant amounts of wealth free of gift and estate taxes. Why not simply make an outright gift? Actually, a gift is the better option, so long as your unused exemption is enough to cover it and you don’t need the funds or the interest income. But if transfer taxes are an issue or if you’re not prepared to part with the money just yet, a loan can be an attractive alternative.
Generally, to pass muster with the IRS, the interest rate on an intrafamily loan must be at least the applicable federal rate (AFR) for the month in which the loan is made. Otherwise, the IRS may view the loan as a disguised distribution, which can result in a variety of unpleasant tax complications.
The loan should also be documented by a promissory note and otherwise treated as an arm’s-length transaction. If the borrower places the funds in investments that enjoy returns that are higher than the interest rate on the loan (not a high bar in the current environment), then the excess appreciation is, in effect, a tax-free gift.
If an intrafamily loan isn’t an option, it may be possible for a trust beneficiary to obtain a loan from the trust. You might wonder why a beneficiary would borrow from the trust rather than take a distribution. There are several situations in which a loan may be necessary or desirable, including:
Be sure to check whether trust loans are permissible. Many trust instruments explicitly authorize loans. But even if the trust is silent, the law in many states permits loans unless the trust expressly prohibits them.
There’s a critical difference between intrafamily loans and trust loans: The trustee has a fiduciary duty to manage the trust in a prudent and impartial manner. If you lend money to family members from your personal assets, you’re generally permitted to structure the transaction as you see fit. However, a trustee considering a loan request must act in the best interests of the trust and all of its beneficiaries. So, for example, a trustee who approves a loan to a current beneficiary who is a bad credit risk is likely breaching his or her fiduciary duty to the remainder beneficiaries.
To fulfill this duty, the trustee needs to treat the loan as an investment of trust assets. That means the interest rate should be reasonable in comparison to other potential investments (the AFR probably isn’t sufficient) and the trustee should consider steps to ensure collection, such as assessing the borrower’s ability to repay and securing the loan with adequate collateral.
Of course, if the terms of loan are comparable to those available from a bank, the trustee should question why the beneficiary isn’t simply obtaining a bank loan. If the answer is that the beneficiary isn’t creditworthy, the trustee should act in the trust’s best interests by rejecting the loan request, increasing the interest rate or demanding additional collateral.
When setting up new trusts, it’s a good idea to address loans in the trust instrument. Whether you permit them or prohibit them, saying so explicitly avoids any ambiguity down the road. Turn to us for additional details.
Here’s an example that illustrates an intrafamily loan’s tax-saving potential. Laura, who has already used up her gift and estate tax exemption, lends $1 million to her son, Eric. The loan calls for annual payments of interest-only — at the AFR, which is 0.5% when the loan is made — followed by a balloon payment at the end of the eight-year term. Eric invests the funds in a business venture that earns a 10% annual return.
At the end of the loan’s term, Eric’s $1 million investment has grown, net the interest at $5,000 per year, to more than $2.5 million. After repaying the $1 million principal, he’s received in excess of $1.5 million gift-tax free.
© 2021