Loans to Trust Beneficiaries

Take-Away: Normally a trustee can make loans to trust beneficiaries, but caution needs to be exercised before the trustee makes the loan.

Background: Last week a trust relationship officer asked if the trustee could honor a beneficiary’s request for a loan from an irrevocable trust when the trust powers were silent on making loans. In response, I confirmed that the trustee did possess such a power to make loans to the trust beneficiary. One of the express powers identified in the Michigan Trust Code’s Specific Powers of Trustee is the power to make loans. [MCL 700.7817(kk).]

“To make loans out of trust property, including loans to a trust beneficiary on terms and conditions the trustee considers to be fair and reasonable under the circumstances. The trustee has a lien on future distributions for repayment of loans made under this subdivision.”

Recall that much of the Michigan Trust Code is set of default rules that apply if a trust instrument is silent. Accordingly, if a trust instrument does not address the power to make loans to a trust beneficiary, or it does not expressly prohibit loans to trust beneficiaries, then the Trust Code’s provisions will supply the missing power. Even if the trust instrument is silent, general legal principles will authorize such loans to trust beneficiaries. However, just because the Michigan Trust Code authorizes loans to a trust beneficiary, that does not necessarily mean that the trustee should always honor the beneficiary’s request and make the loan.

Situations When a Loan to the Beneficiary Might be Appropriate: Some examples when a loan to a trust beneficiary might be appropriate follow:

Preserve GST Exemption: A trust is exempt from GST tax. The trust is established for the benefit of the settlor’s child and grandchildren. The child is in financial distress and needs financial help. A distribution from the trust to the child would effectively ‘waste’ part of the settlor’s GST exemption that was allocated to the trust, as the child is not a skip person. While there may be worries about the child’s ability to repay the loan, by making a loan the trustee at least preserves the possibility of a repayment by the trust beneficiary and hopefully preserves the GST exemption with regard to the loaned amount.
Preserves Equal Treatment: A trust is established for multiple present trust beneficiaries. One current trust beneficiary requests a disproportionate distribution from the trust. A loan, as opposed to an outright distribution, enables the trustee to continue to treat all of the trust beneficiaries equitably, if not equally. The other trust beneficiaries may strongly oppose disproportionate distributions to one of their group of several beneficiaries. The loan finesses this perception of unequal treatment (assuming the interest rate charged on the loan is fair and the loan is adequately secured.)
Preserves Settlor’s Intent: A trust provides for income distributions only. Or, the trust imposes a dollar limit on the amount that the trust can distribute annually to the trust beneficiary. The beneficiary’s request for a distribution exceeds the income or dollar limitations imposed by the trust instrument. A loan to the trust beneficiary can be viewed as abiding by the limitations imposed by the trust instrument, and thus carries out the settlor’s intent (unless the trust instrument expressly prohibits making loans to the trust beneficiary.)

What to Consider in Responding to a Request for a Loan:

A Good Idea?: Is the loan a reasonable use of trust assets? Other trust beneficiaries might strongly object if the loan is either low-interest bearing, or interest-only with a balloon payment years into the future. With a loan, the trust forgoes other investment opportunities along with their associated returns. If the trustee decides to charge a commercial lender’s normal interest rate for the loan, then that begs the question why the beneficiary is coming to the trust for a loan, unless the beneficiary presents other risks of non-payment that the trustee must be equally attuned to and protect itself against.
Spendthrift Limitations: Most trust instruments contain a spendthrift limitation. The power to make a loan to a trust beneficiary does not override the spendthrift limitation. A spendthrift limitation will restrict the trustee’s ability to take a lien on future distributions to the trust beneficiary to secure the repayment of the loan, or the pledge of the trustee’s interest in the trust to guaranty the beneficiary’s repayment of the obligation. If the trust instrument contains a spendthrift limitation, the trust should also identify that the trustee may accept as security liens on future distributions to the trust beneficiary, notwithstanding the trust’s spendthrift provision.
Duty of Impartiality: The trustee owes a fiduciary duty of impartiality to all trust beneficiaries, along with the duty to manage trust assets with care and prudence. Other trust beneficiaries might be very unhappy if some income producing assets of the trust are liquidated (with a capital gains cost) in order to make a loan of cash to one trust beneficiary. In addition, the loan would be viewed by other beneficiaries as forgoing other investment opportunities. In short, a loan to one beneficiary using a below market interest rate, or without adequate security, could readily be viewed as a breach of the trustee’s fiduciary duties to other trust beneficiaries. To preserve harmony with the other beneficiaries of the trust, the trustee should ask for a written statement of non-objection from the other trust beneficiaries to the proposed loan to the one trust beneficiary. A non-objection is safer than a consent from the other beneficiaries to avoid any indication of a gift among the trust beneficiaries, (if, for example, a below market interest rate is used for the loan.)
Loan Re-characterization: The trustee always needs to be concerned that the IRS might try to re-characterize the loan as a disguised trust distribution, which in turn carries out distributable net income (DNI.) Additionally, if an outstanding loan to a trust beneficiary is frequently refinanced to reflect lower prevailing interest rates, it is possible that a series of loan refinances might also be viewed by the IRS as a disguised trust distribution, i.e. a loan that will never be repaid by the borrower. Rather than accrue interest with a balloon payment many years later, the note should require at least annual payments of interest and preferably some repayment of the principal balance due on the note to refute that the loan is really a disguised distribution. The promissory note signed by the beneficiary-borrower should be signed contemporaneously with the transfer of funds to the beneficiary, not after the funds have been released from the trust.
Loan Term: The trustee needs to consider if there will be a time when the beneficiary-borrower will be able to repay the loan. Will there be some external event, like the beneficiary receiving an inheritance, from which the loan can be repaid? Or will the trust at some future time, or upon a specified event, be divided into separate shares, when the beneficiary will be entitled to a distribution from the trust from which the loan can be satisfied. The loan should come due before the end of a term of years, or upon a specified event, e.g. the death of the beneficiary’s ancestor. A demand note should be avoided because of the on-going re-calculations of the accrued interest on the demand note.
Interest Rate: The Applicable Federal Rate (AFR) under IRC 7872 applies to loans by trustees. A below-market loan to the trust beneficiary will be re-characterized as a portion, or all, of the loan as a taxable gift by the lender. The below-market loan will require that (i) the trust will be treated as having made a distribution to the beneficiary-borrower in an amount equal to the difference between the actual interest rate charged and the required AFR; and (ii) the beneficiary-borrower will be treated as having paid interest at the required AFR back to the trust. This interest payment is taxable income to the trust. As a result, it is important to avoid this imputed distribution and the associated complicated income tax results for the trust. Interest should be charged at least at the AFR rate, if not the a fair market rate that a commercial lender would charge. Preferably the interest rate charged would be under a term loan that is fixed for the entire term of the loan, which makes the calculation of interest on the note far easier for the trustee to administer. Depending upon the borrower’s risk of non-payment, the trustee might even consider charging ‘junk bond’ rates of interest to reflect that risk.
Collateral Security: Taking security for the loan is necessary to protect the trust’s investment, and also necessary to protect the trust in the event that the beneficiary-borrower defaults on the loan. Security should take the form of a mortgage, a UCC filing statement, or a more formal Security Agreement or Pledge of assets, all of which become part of the trustee’s official records.

Conclusion: While a trustee can normally make a loan to a trust beneficiary, there is a lot to consider from a fiduciary duty, tax, and asset preservation perspective. This is not to say that loans should never be made from a trust to a beneficiary, but much more thought needs to go into the terms of the loan, the interest rate charged, when and how the loan will be repaid, the collateral furnished to the trustee, and the trustee’s duty of impartiality to all trust beneficiaries.