Intrafamily loans offer family value

Steve Koh, Vice President
December 13th, 2018 | 2:30 PM

When children or other family members need financial assistance, it may be tempting to simply hand them a check. But lending — rather than giving — money to your loved ones offers several advantages.

COUNT THE BENEFITS

Why might loans be better than gifts? For starters, if you’re concerned about whether you’ll be able to save enough for a comfortable retirement, lending allows you to help family members without losing the funds permanently. Also, loans can help teach financial responsibility. If you feel that your children — or even adult family members — aren’t as prudent with their money as you’d wish, a regular repayment schedule may instill the kind of discipline they need.

Also, if you’re concerned about estate taxes, intrafamily loans can be an effective vehicle for transferring wealth tax-free. The amount by which the borrower’s investment returns exceed the interest paid on the loan is essentially a tax-free gift.

The recently enacted Tax Cuts and Jobs Act (TCJA) doubled the estate, gift and generation-skipping transfer (GST) tax exemptions to $11.18 million ($22.36 million for married couples), so only a much smaller group of families are subject to these taxes. Nevertheless, intrafamily loans may still make sense. Exemption amounts are scheduled to revert to their pre-TCJA levels in 2026, and there’s no guarantee Congress won’t reduce them even further in the future. Intrafamily loans and other estate planning vehicles can help protect your wealth against future transfer taxes by preserving your exemptions

MAKE IT OFFICIAL

To avoid unwelcome tax consequences, you’ll need to structure your intrafamily loan as a legitimate, arm’s-length transaction. Most important, charge interest at or above the current applicable federal rate (AFR). Otherwise, you’ll be subject to income tax on imputed interest — the excess of the AFR over any interest you actually collect. Imputed interest also may be treated as a taxable gift to your borrower.

In addition, you should:

•   Memorialize the loan with a promissory note,
•   Establish a fixed repayment schedule,
•   Ensure that the loan is actually repaid when due, and
•   Obtain adequate collateral or other security, if possible.

In other words, treat your intrafamily loan like a loan to a stranger.

BANK ON IT

Finally, to ensure the desired tax treatment of intrafamily loans, affluent families might consider establishing a “family bank.” This is a family-funded entity, such as a trust or limited partnership, designed to make loans to family members. By “professionalizing” the lending process, a family bank can help ensure that loans satisfy IRS requirements and meet lending objectives.

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