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George F. Bearup, J.D. Senior Legal Trust Advisor

July 7, 2023

Interest-Free Loans to Trust Beneficiaries – Really?

Take-Away: Intra-family loans that use the AFR rate of interest is a great way to shift wealth gift tax-free. Intra-family loans can also be made interest-free, but then that causes a taxable gift to be made. Is it possible for a trustee to make an interest-free loan to a trust beneficiary using trust assets? Maybe, but the trustee may have to ‘thread-the-needle’ to reach the tax-free outcome.

Background: Generally loans are often made with some reference to the monthly published applicable federal rates of interest (AFRs.) If an intra-family loan is made and the loan carries the current AFR when the loan is made, no implied gift element is associated with the loan.

Trustee Loans: The Michigan Trust Code contains as one of the default powers of a trustee the ability to loan trust property to a trust beneficiary on terms and conditions that the trustee considers to be fair and reasonable under the circumstances. [MCL 700.7817(kk).] What about the trustee making a below-market interest rate loan to a trust beneficiary? Or even an interest-free loan to the trust beneficiary? Is an interest-free loan to a trust beneficiary fair and reasonable under the circumstances?  One of the recent proposals in the Treasury’s 2024 Greenbook to raise revenues to pay next year’s federal budget is to treat loans from trusts as trust distributions to “divorce the [beneficiary’s] ability to benefit from trust assets from the receipt of income for tax purposes, thereby allowing them to inappropriately avoid income and GST taxes.”

IRC 7872: A corollary to the general rule that no implied gift is made if the appropriate AFR is used with a loan is IRC 7872, which codifies the gift and income tax treatment of some below-market loans.  IRC 7872 was the 1986 legislative response to the U.S. Supreme Court decision in Dickman v. Commissioner, 465 U.S. 330 (1984.) In that case the Court held that interest-free demand loans between family members resulted in taxable gifts, and that the right to use money is a property interest. As a result, the gratuitous transfer of the right to use money is a transfer of property for gift tax reporting purposes. The value of the taxable gift of a below-market loan is the reasonable value of the use of the money.

Below-market Loan: A below-market loan is one where the amount of interest that would have been payable on the loan at the AFR exceeds the amount of interest that is actually payable under the loan. Unfortunately, the application of IRC 7872 is a bit convoluted. IRC 7872 treats the forgone interest on a below-market loan as if property is: (i) transferred from the lender, (ii) to the borrower, and (iii) subsequently re-transferred from the borrower back to the lender. Then there are the deemed rules-

Deemed Transfers: The character of the step (i) transfer noted above depends on the relationship between the lender and the borrower and the purpose of the loan. By way of example, under IRC 7872 the deemed transfer of forgone interest from the lender to the lender’s employee is normally is to be classified as taxable compensation. A below-market interest loan from a mother to her daughter will likely be characterized by IRC 7872 as a deemed taxable gift.

Gift Loans: If a gift loan is also a term loan, for federal gift tax purposes the lender is deemed to have transferred to the borrower on the date the loan is made an amount that is equal to the excess of the amount loaned over the present value of all payments that are required to be made under the loan. However, for income tax reporting purposes, the lender is treated as having transferred and received an amount equal to the forgone interest on the last day of each year. [IRC 7872(d).]

Demand Loans: In the case of a demand loan, the transfer of the forgone interest from the lender to the borrower, and the subsequent re-transfer from the borrower to the lender, are deemed to occur on the last day of each calendar year that the loan remains outstanding. [IRC 7872(a).]

Term Loans: With a term loan, other than a gift loan, the lender is deemed to transfer to the borrower on the date the loan is made an amount that is equal to the excess of the amount that is loaned over the present value of all payments required to be made under the loan. [IRC 7872(b).] The present value is determined by reference to the AFR on the date that the loan is made.

OID: A below-market term loan is treated as having original issue discount (OID) that requires the lender to ratably recognize the forgone interest over the term of the loan. [IRC 1272.] The OID tax rules under IRC 1272 and related sections are intended to identify and tax deferred interest income and force borrowers and lenders to recognize that income in appropriate time periods.

Scope of IRC 7872: According to the Joint Committee on Taxation comments, IRC 7872 only applies to below-market loans that fall into six (6) categories that are defined by the statute (excluding s few de minimus situations):

  • Gift-loans;
  • Compensation-related loans;
  • Corporation-shareholder loans;
  • Loans in which one of the principal purposes is the avoidance of federal tax, known as tax-avoidance loans;
  • Loans the interest arrangement of which have a significant effect on any federal tax liability of the lender or the  borrower, known as significant effect loans; and
  • Loans to continuing care facilities

Loans by Trustees: If these six (6) categories are applied to an interest-free loan from a trustee to a trust beneficiary, only three categories actually apply: the gift-loan, the significant effect loan, and the tax-avoidance loan.

Gift-Loan: Trustees normally do not make gifts. The gift tax rules do not apply to treat transfers from a trustee to a trust beneficiary as a gift. Treasury Regulations provide that “a transfer by a trustee of trust property in which he has no beneficial interest does not constitute a gift by the trustee.” [Regulation25.2511-1(g)(1).] Looked at another way, a when a trustee lends money to a trust beneficiary, the trustee  merely permits the beneficiary to the use of property in which the beneficiary already possesses a beneficial interest. If the trustee distributed cash to the trust beneficiary instead of making a loan, the resulting transfer to the beneficiary would not be characterized as a gift, but a trust distribution. As such, an interest-free or below-market loan from a trustee to a trust beneficiary will probably not be characterized as a gift-loan.

Significant Effect Loan: While the terms of the statute gives regulatory authority to the IRS to extend IRC 7872 to below-market loans not otherwise subject to that Tax Code section if the interest arrangements have a significant effect on the federal tax liability of the borrower or the lender, surprisingly the proposed Regulations do not exercise this power- “[N]o transaction will be treated under the regulations as a significant effect loan earlier than the date that future regulations under 7872(c)(1)(E) are published in proposed form.” [Preamble to Proposed Regulations, August 20, 1985.] Thus, 38 years later after this section of the Tax Code was adopted,  there still are no proposed regulations with respect to the significant effect loan category. With that lack of any direction or guidance, an interest-free loan from a trust to its beneficiary should not be characterized as a significant effect loan  subject to IRC 7872.

Tax-Avoidance Loan: Exposure to IRC 7872 under this category of loan is less clear as it is dependent upon the underlying facts if tax avoidance is a principal purpose of the interest arrangement agreed upon in connection with the loan. More to the point, there is virtually no guidance on below-market-tax-avoidance loans. Accordingly, much will depend upon the underlying reasons why an interest-free loan was made by the trustee to the trust beneficiary in order to avoid IRC 7872.

Example: Terry, the trust beneficiary of a discretionary trust, seeks a distribution from the trust to purchase a home. Terry is the lifetime beneficiary of the trust, and on his death the assets are then distributed to Terry’s descendants. Terry is adamant that the title to the home must be in the joint names with Terry and his wife, Sandy. But Sandy  is not a trust beneficiary. With the ‘condition’ that Sandy’s name be on the title to the home,  the trustee is reluctant to make the cash distribution for the home’s purchase to Terry. The trustee would like Terry to have the use of the loaned funds to purchase the home without having to be concerned about investing some of those loan proceeds in a way that provides liquidity for annual interest payments that would otherwise be required on a below-market loan. These might be good reasons for a below-market, or even an interest-free loan to Terry.

Or, perhaps Terry only needs enough to make the 20% downpayment for the purchase of the home, borrowing the balance with a conventional bank mortgage loan. An interest-bearing loan from the trust to Terry would negatively impact his ability to qualify for the third-party loan arrangement, or to support Terry’s separate family business.

Or, the trustee may simply want to avoid the hassle of collecting interest on the loan to Terry, who seems to lack the ability to live on a budget.

In light of the example(s) there could be several reasons why a trustee is willing to make an interest-free loan to a trust beneficiary without there being a tax-avoidance purpose for the loan.

Practical Observations: To minimize the risk of IRC 7872 applying to a loan to a trust beneficiary, a few logical steps should be taken:

The trust instrument should expressly waive or release the trustee from any fiduciary duty of impartiality between current and remainder or future trust beneficiaries, placing a priority on the needs and welfare of the current trust beneficiary over the beneficial interests of remainder trust beneficiaries. The fiduciary duty of impartiality can be waived under the Michigan Trust Code. [MCL 700.7803; MCL 700.7105(1).]

The trust instrument should expressly authorize the trustee to make below-market or interest-free loans to current trust beneficiaries. This provision would outweigh the default Trust Code power to make loans fair and reasonable. [MCL 700.7817(kk).]

The trust instrument might give the trustee the power to separate the trust corpus into two separate trusts, one that consists of the loan made to the current trust beneficiary and the other that consists of the balance of the trust’s assets.

The loan should be documented and fully secured to assure repayment at a future date, perhaps with future interest payment obligations if the borrower fails to pay a required installment.

Conclusion: Below-market loans always carry some risk of a gift or income tax consequence. It may be possible for a trustee to make a below-market or even an interest-free loan to a trust beneficiary in light of the specific facts and circumstances. While not free from doubt, in many cases the facts and circumstances will reasonably support a conclusion that an interest-free loan from a trust to a beneficiary is not subject to IRC 7872.