Interest rates are at historic lows. Family members may need help with financial or business transactions. This combination creates an opportunity for significant transfer tax savings for persons with the means to help their family members financially. This e-alert discusses the attractiveness of the "intra–family loan" (a loan made from one family member to another (or to a trust for another)) in this current low interest rate environment.
Why do the current low rates matter? Can't I just charge a family member the rate I want?
If the interest rate on a loan is lower than the IRS thinks it should be (a "below market loan"), there can be negative tax consequences that you generally want to avoid.
When making any loan, the lender should always be careful to structure the loan to avoid it being a "below market loan." A below market loan exists if the interest rate charged on the loan is lower than something called the applicable federal rate
(commonly referred to as the "AFR"). AFRs are issued monthly by the IRS.
If the interest rate charged is less than the applicable AFR, tax rules require the lender to recognize taxable interest income equal to the difference between the rate charged and the AFR. This is true even though no income is actually received by the lender (sometimes this is called "phantom income"). This phantom interest income will also be deemed a gift from the lender to the borrower.
Minimum Interest Rates for Intra-Family Loans in December 2013
The AFR is extremely attractive when compared to average market rates currently available from commercial lenders. The following chart shows the AFR applicable (depending upon the length of the obligation) for intra–family loans made in December 2013 (assuming payments are made annually):
Short Term Loans (3 Years or Less) --- 0.25%
Mid Term Loans (More than 3 Years but Less than 9 Years) --- 1.65%
Long Term Loans (More than 9 Years) --- 3.32%
Because the AFR is currently historically low, families have the opportunity to provide capital as needed at very low cost and still avoid having the transaction trigger to the below market loan income and gift tax trap described above.
Beneficial Uses of Intra-Family Loans
Intra-family loans can be useful in a number of contexts.
Child Needs Loan for Investment.
Instead of going to a bank, a child could seek a loan from a parent to acquire funds desired by the child for purchase of an asset such as a closely held business interest, an attractive investment opportunity, or even a home. Borrowing from a parent has a number of advantages to the child:
Parent Wants to Shift Wealth.
Closing costs encountered with commercial lenders can be avoided;
Interest paid to a parent remains "in the family"; and might come back to the child by gift or inheritance; and
A child who has poor or below average credit would not be required to pay a punitively high interest rate that might be charged by a commercial lender.
Intra-family loans offer the opportunity for a high-net-worth parent to shift wealth out of the parent’s estate for transfer tax purposes.
Loan to Purchase New Asset. Parent loans cash to child to acquire investment that has income and appreciation potential greater than the AFR. Parent will have essentially made a gift-tax free transfer to the child of all income and appreciation that exceeds the AFR.
Loan to Acquire Existing Family Asset. Parents own interest in family limited partnership ("FLP") that manages family investments. Parents desire child to participate in the FLP as a limited partner, but do not want to give the entire asset to the child. Parents could sell the partnership interest in exchange for a note, as described in the examples below. In both of these examples the limited partnership interest would be owned by the child or a trust, and all that would be included in the parents' estate would be the unpaid balance on the promissory note. This strategy effectively "freezes" the value of the transferred asset at its fair market value on the date of transfer.
Simple Plan. Parents could sell a limited partnership interest in the entity (hopefully taking advantage of minority interest and marketability discounts which may be applicable) to child in exchange for a low interest note. This transaction could work much like the basic loan to a child for investment described above. If the loan is made from the parent to the child directly, the parent will have to pay income tax on the interest income received from the child. Accordingly, income tax consequences should be considered prior to implementing any intra-family loan.
More Robust Plan. Parents could sell a limited partnership interest in the entity to a trust created for the benefit of the child and the child's descendants, still in exchange for a low interest note. The trust would likely be structured in a manner so that the trust's assets would not be included in the parents' estates for tax purposes, but parents would be responsible for paying income taxes on trust income (a "grantor trust"). With a grantor trust parents may sell assets to the trust in exchange for a note without triggering any gain or loss, and the parents would not pay tax on the interest income received (they would pay tax on all trust income, however, as described above). In this scenario, not only do the parents achieve a shift of wealth, but the child benefits from a trust which could be beyond the reach of claims of creditors or spouses and which can grow free of income tax until the parents die (or decide to no longer pay the income taxes). One of the other powerful aspects of this strategy is that the parents' payment of the income taxes for the trust is not considered a gift for federal gift tax purposes.
Parent has Otherwise Used Available Exemptions. In 2013, each person may make lifetime gifts of up to $5,250,000 before owing a gift tax (the exemption rises to $5,340,000 in 2014). Many persons have already made large gifts using their available lifetime gift exemptions. For those persons, the intra-family loan may be a great choice for assisting loved ones while making further transfer-tax free transfers of wealth.
Structuring the Intra-Family Loan to be Respected by IRS.
Although intra-family loans have many benefits, they also bring the burden of proper bookkeeping and accounting.
If an intra-family loan is desired, it should be properly structured and maintained as a bona fide loan. In the family context, the IRS is especially sensitive to loans which in its view may be disguised gifts. The following steps can be taken to guard against IRS arguments that a gift, rather than a loan, has been made:
execute a written promissory note;
develop a fixed repayment schedule;
set the interest rate at or above the AFR in effect for the month the loan is originated;
secure the debt with collateral;
make sure the borrower is in fact solvent at the time of the loan (in the case of the above described sale transaction to the trust, a gift down payment equal to 10% of the fair market value of the asset being sold is recommended); and