Note: This article was updated as of August 18, 2021.
The concept of a “family bank” has become a more prevalent tool among wealthy families. Traditionally, the arrangement seeks to leverage cash from the senior generation to benefit the junior generation without a focus on optimizing loan return. Under the right circumstances, these intrafamily loans can retain substantial assets within a family unit while providing relatively cheap access to capital for junior generations.
Loans between family members seem straightforward, but the devil is in the details. Luckily, proper loan structure and administration can serve to avoid any negative income, gift and estate tax issues.
Lending Benefits
Intrafamily lending is most commonly structured as a loan from a parent to a child to confront a specific financial obstacle. In the purchase of a home or business, launch of a professional endeavor or repayment of student loans, intrafamily lending can soften the most stressful financial circumstances. When used in purchasing a home, an intrafamily loan can allow a loved one to purchase a residence that he or she might not qualify for under traditional lending standards. An intrafamily loan might also ease the burden of debt service by setting an interest rate below comparable commercial alternatives. If assisting children or other loved ones in the start-up of a business or profession, a loan can be made to an individual who lacks a robust credit history or the required collateral. In the student loan context, an intrafamily loan can allow for consolidation of payments with one lender under a lower interest rate without collateral requirements. In all these examples, the lender provides a tangible benefit to the borrower while receiving an income stream and retaining assets within the family unit.
Below Market Rate Loans
The IRS publishes monthly interest rates that establish the minimum rate required to avoid negative income tax consequences. The IRS provides separate rates for short-term loans (three years or less), mid-term loans (over three years but less than nine years) and long-term loans (over nine years). For September 2021 obligations with an annual payment schedule, the Applicable Federal Rate (AFR) is 0.17% for short-term loans, 0.86% for mid-term loans and 1.73% for long-term loans. Compare those rates to commercially available 30-year fixed rate mortgages with interest rates around 3% at the same time. These rates change monthly and you can find the applicable AFR for a given month here.
Best Practices for Managing Intrafamily Loans
- Have the borrower sign a promissory note to formally establish the loan
- Establish a fixed repayment schedule
- Charge interest at or above the minimum “safe harbor” rate (AFR) to avoid below market rate loan status
- Consider term loans (interest rate fixed at creation) rather than demand loans (interest rate compared to the monthly AFR throughout the loan term) to avoid the complexity of administering a floating interest rate
- Request collateral from the borrower (if appropriate)
- Require timely repayment
- Have records from both parties establishing the debt and evidencing payments
- Make sure that the borrower has the wherewithal to repay the loan
- Do not pre-establish a plan to forgive payments as they come due (although very common, a pre-arranged plan may establish that the loan was never a bona fide debt and the transfer was a disguised gift)
- Engage your tax advisor to understand preferred lending terms and potential income tax consequences
Best Practices
The IRS is increasingly suspicious of intrafamily loans, given the potential benefits to both borrower and lender. In order to effectively create a respected loan transaction, consider adhering closely to the listed best practices.
Non-Financial Considerations
Intrafamily loans introduce dimensions not present in commercial lending that may disturb harmonious family relationships. Parents lending money to a child may want to consider the broader perception of that loan among others. For example, a loan to one child may create expectations or resentment among others. Accordingly, if parents have a strong desire to treat children equally, they should consider whether they are willing to make a loan of equal value to all children.
Besides a broader family impact, intrafamily loans create a business transaction that alters traditional parent/child roles. Additional functions as lender and borrower emerge with the creation of a loan. Should the borrower child have difficulty repaying the loan or use loan funds towards questionable purchases, the lender parent may not respond positively. Relationship strain is a normal part of family dynamics, but that tension is accentuated when a loved one is also a creditor or borrower. Before entering into a loan arrangement, the involved family members should be comfortable with the potential new dynamics the loan will create among the individual participants and the broader family unit. Setting appropriate and reasonable expectations among both parties in advance is strongly encouraged.
Estate Planning and Loans
Intrafamily lending can be a rather efficient estate planning strategy and potential investment arbitrage opportunity, especially in a low interest rate environment. Consider a scenario where the senior generation lends funds to the junior generation at the lowest permissible interest rate (AFR). The expectation is that during the term of the loan the junior generation invests those funds and earns a return in excess of the AFR. Any “excess return” during the term belongs to the junior generation without gift tax consequence. Wealth transfer may occur, assuming investment returns exceed the AFR, without use of any annual gift tax exclusion or lifetime gift tax exemption. Additionally, the “excess return” avoids potential estate tax in the senior generation’s estate.
When to Gift
Intrafamily lending has many advantages, but there are situations where an outright gift may be more appropriate. If a lender does not need to be repaid or the borrower’s ability to repay is questionable, it may be advantageous to make a gift using the lender’s lifetime exemption or annual gift tax exemption. Making a gift eliminates having the value of the note included as an asset of the lender’s estate in the event that the lender dies while the note is outstanding. It also avoids any potential negative income, gift and estate tax consequences if required interest and principal payments are not made or the terms of the loan are otherwise not met.
Conclusion
Intrafamily lending can be a great tool to assist junior generations through financially impactful moments. By following best practices, senior generations can avoid negative income and gift tax consequences while allowing effective use of family resources.
If you would like more information or would like to brainstorm on how this might benefit your family, feel free to reach out to your Wetherby team.