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

13-Apr-17

Intra-Family Loans – Estate Planning Made Easy

Take-Away Message: While many clients await the promised tax law ‘reform’ from a Republican-controlled Congress, there are still many  basic estate planning techniques that can be exploited to shift wealth gift-tax free and with virtually no cost or risk to the client. One of the easiest  of these techniques is an interest-free loan, or a low interest loan, to a family member who is in a lower marginal income tax bracket than the lender.

Context: As you have repeatedly heard from me over the past several weeks, it is probably a mistake for clients to ‘do nothing’ with their estate plans pending the expected Congressional changes in the estate, GST, and maybe gift, tax laws. Perhaps the failure of the Republican controlled Congress to immediately repeal the Affordable Care Act as promised might be a wake-up call for those clients who have assumed that ‘tax reform’ was a foregone conclusion this calendar year. Nothing is certain these days when it comes to Congress- other than a lot of hot air. Consequently, some modest  estate planning strategies should be considered by clients while they await the promised end of the dreaded death tax. One such strategy is a low-interest loan to family members.

Planning Strategy: An intra-family loan is an easily implemented estate planning technique that requires only a promissory note to document the loan. To the extent the borrower, e.g. a grandchild, is able to invest the loan proceeds to achieve an investment return higher than the interest rate charged in the promissory note, assets will be shifted on a gift-tax-free, GST-tax-free, basis from the lender to the borrower. The chances of this loan strategy’s success is enhanced if the loan is interest-free, but if no interest is charged on the promissory note  a gift tax  will have to be reported by the lender.

  • Interest Charged: The short-term IRC 7520 interest rate for April, 2017 is 1.11%, if the loan interest is paid annually. That means that if a loan is made to a family member this month, and the loan proceeds are invested by the borrower, and the annual investment return to the borrower is 4.0% over the next 12 calendar months, the difference [4.0% -1.11% = 2.9% excess return] passes to the borrower gift-tax free.
  • Example: Grandmother loans to her grandchild $500,000 for one year. She charges interest of 1.11% on that outstanding loan. A year later the grandmother’s loan comes due with an interest payment from her grandchild of $5,500. If the $500,000 is invested by the grandchild and produces a return of 4.0%, at the end of the 12 months the grandchild will have a gross return of $20,000 from the invested $500,000. After the loan and interest are repaid to the grandmother, the grandchild will retain net taxable income of $14,500. If the grandchild is in the marginal 10% federal income tax bracket, the grandchild will have, net of his/her own federal income tax liability, about $13,050. No gift tax nor any generation skipping transfer tax will be imposed on this indirect transfer of $13,050 wealth to the grandmother by his/her grandparent. If desired, the grandmother can still gift another $14,000 to her grandchild in the same year using the federal gift tax annual exclusion; the $13,050 is not considered a gift by the grandmother to her grandchild.
  • Interest-Free: The Supreme Court  held years ago that the right to use money is a property interest. Consequently, the gratuitous transfer of that right is a property transfer within the meaning of the federal gift tax laws. [IRC 2501(a).] The gift tax value of that property transfer is the reasonable value of the right to use the loaned funds. Dickman v Comm’r 465 US 330, 332 (1984). After Dickman Congress passed IRC 7872 which provides that a demand loan is a below-market loan if the interest rate charged on the loan is calculated at a rate lower than the applicable federal rate [which is determined and published monthly.] The applicable federal rate is the federal short-term interest rate that is determined under IRC 1274(d). Thus, a loan is treated as a gift-loan if the lender forgoes interest on the loan. IRC 7872 treats:  (i) the ‘forgone’ interest on a demand gift-loan as a taxable gift to the borrower from the lender of the amount of the forgone interest;  (ii) followed by a deemed payment of the interest amount back to the lender, as taxable income to the lender as of the last day of each calendar year. IRC 7872(f)(2).
  • Exceptions: Not all below-market loans are governed by IRC 7872. Married spouses as one person under the Code Section; in other words, it does not apply to inter-spousal Moreover, the Code Section specifically excepts gift-loans between individuals if the loan is not more than $10,000. An inter-spousal loan would be protected by the unlimited federal gift tax marital deduction [IRC 2523(a)]. Unclear is how the IRS would  tax  an intra-family loan below $10,000 because it has not provided any Regulations on that question. Obviously, not a lot of wealth would be shifted with an interest-free $10,000 loan these days.
  • Summary: If the interest rate of the promissory note is the federal short-term interest rate for the month when the loan was made, the note’s value will be its face value, and no gift tax or GST tax will be imposed. If there is no  interest charged on the note, or the interest rate used is less than the federal short-term rate, the amount of the reportable gift made by the lender will be limited to the forgone interest on the loan using the IRC 1274(d) rate for the month the loan was made which is the difference between the published AFR short-term rate and the rate actually charged on the loan.

Use of Property:  IRC 7872 applies to more than loans of cash. It also applies to loans of tangible personal property. But the IRS has yet to provide any guidance on how to value the gift element of a loan of tangible property to another individual. The Court in Dickman did address a grant by a parent to a child of the rent-free, indefinite use of, commercial property as a transfer of a valuable property right that would cause a gift of some sort to be made by the parent. But at the same time the Dickman Court noted that it assumed that the IRS would not tax traditional familial use transactions such as when a parent gives an adult child the use of an auto or the use of the parents’ vacation cottage. Perhaps this traditional familial exclusion turns on the Court’s observation that the “right to use property is an interest in property to the exclusion of others.” With that exclusion of others qualifier, so long as the use right of use granted to a child or grandchild is simply the right to share property with the owner, and not the exclusive right to use it to the exclusion of the owner, that right probably will not rise to the level of a property right, or it will be so difficult to value that that the imposition of a gift tax will be impractical. But merely having possession of tangible personal property  implies some level of exclusivity by the person in possession.

  • Example: I borrow my mother’s pontoon boat. I have friends who will rent a cottage for the week. My friends want to rent a pontoon boat for that week they are at their cottage. I lease my friends the pontoon boat and charge them $250 in rent. Has my mother made a gift to me of $250?  Practically speaking, I seriously doubt if any clients actually report as a gift the value of the use of tangible property on any gift tax returns, but this is one of those gray areas. A week’s use of a my mother’s pontoon boat is far different than a month’s use of my mother’s Maui condominium in February.

Structuring the Note: Despite its simplicity, an intra-family loan can still attract a variety of arguments from the IRS that the promissory note is not bona fide indebtedness, or that the loan is really equity owned by the lender. If an intra-family loan is contemplated, consider using the following checklist of best practices:

  1. Have the borrower sign a promissory note;
  2. Establish a fixed repayment schedule for the note;
  3. Charge interest on the note at or above the minimum AFR’s ‘safe harbor’ rate;
  4. Request collateral security from the borrower;
  5. Demand repayment when the promissory note comes due (to avoid claims of a pre-existing arrangement that the loan was going to be forgiven;)
  6. Have the records from both lender and borrower reflect the debt;
  7. Retain evidence that the payments were actually made under the promissory note;
  8. Confirm and document that the borrower has the wherewithal to repay the loan when initially given;
  9. Do not establish any plan to forgive the loan payments as they come due; and
  10. If the promissory note is refinanced,  use the then-prevailing AFR rate if unpaid interest is added to principal and reflect the records accordingly as to the new rate charged.

Conclusion:  A low (or no)  interest loan to a family member who is in a lower marginal income bracket is a simple way to shift income, and thus wealth, away from the lender, which reduces the lender’s taxable estate, and arguably reduces the lender’s own income tax liability, i.e. less reportable income; possibly escaping net investment income 3.8% tax exposure; possibly avoiding phase-outs of some income tax deductions, etc. A simple promissory note is the only instrument that is required to implement the strategy, but accurate records of payments will need to be maintained in the future event that the intra-family loan transaction comes under IRS scrutiny.