Back to Missives
George F. Bearup, J.D. Senior Legal Trust Advisor

11-Sep-19

Shifting Wealth Tax-Free by Intra-Family Loans

Take-Away: An intra-family loan is a simple and understandable way to shift wealth from an individual in a high income tax bracket to an individual in a lower income tax bracket. Structuring that loan,  however, is critical in order to avoid an implied gift under the Tax Code.

Background: We know that funding a grantor trust is an excellent way to shift wealth gift tax-free. The grantor pays the income taxes on the grantor trust’s income, thus permitting the assets inside the grantor trust to grow in a tax-free environment. Specifically, the grantor is not treated as making a gift (of the income taxes the grantor pays, on the trust’s income) to the trust beneficiaries. Similarly, a grantor retained annuity trust (GRAT) is a way to shift wealth to others, often family members or trusts for their benefit, gift tax-free, just so long as the investments held in the GRAT perform better than the required federal interest rate that is used to calculate the settlor’s retained annuity. Each is often used when the desire is to shift wealth, but also retain access to the transferred asset should the grantor needs change. However, both of these estate planning techniques require the use of trusts, and each carries some risks that can make an individual uncomfortable when considering the shift of wealth. Yet another way to possibly shift wealth, gift tax-free, while arguably retaining access to the transferred asset is a simple loan to a family member.

Intra-family Loans: This same type of wealth shifting from a high-tax-bracket individual to a low-tax-bracket individual can be achieved with an intra-family loan. Income earned on the loaned proceeds is taxed to the borrower in the lower marginal income tax bracket (compared to the lender’s higher income tax bracket.) The assumption is that the borrower will invest the loaned proceeds and receive a greater return than the interest rate that is charged to the loan proceeds, which results in a net positive outcome for the borrower. This loan arrangement works reasonably well in a period when interest rates (and prices) are rising, and not so well, if at all, if interest rates (and prices) are expected to fall. In addition, with a loan, which is secured by the borrower’s collateral, the acquired assets are better protected if the borrower runs into creditor problems, as the lender will have priority access to the assets that are acquired with the loan. Inherent in the intra-family loan arrangement, however, is the exposure to the possible imposition of an implied gift if the interest rate charged is ‘too low’ or interest is permitted to accrue on the loan balance. Navigating the Tax Code’s interest rate and original discount rules can thus present a challenge.

IRC 7872: Adopted in 1984, this Code section was created to expressly address the tax treatment of loans with below-market interest rates. IRC 7872 uses what is commonly referred to as the applicable federal rate, or AFR rate, which is published monthly by the Department of Treasury. The AFR rate is different for a term loan from a demand loan. For a term loan if the interest stated is no lower than the AFR rate for the date that the loan is made, there is no implied gift. If the loan is a demand loan, there is no implied gift if the interest rate charged on the loan is no lower than each semi-annual period that the loan is outstanding. Consequently, adhering to the relevant 7872 rate avoids an imputed gift by the lender.

AFR Rates: For this month, September, the following AFR rates were published by Treasury:

  • Short-term loan (0 to less than 3 years) 1.85% annual payment, 1.84% semi-annual payment, 1.84% quarter-annual payment, and 1.83% monthly payment
  • Mid-term loan (3 years to less than 9 years) 1.78% annual payment, 1.77% semi-annual payment, 1.77% quarter-annual payment, and 1.76% monthly payment
  • Long-term loan (9 years or longer) 2.21% annual payment, 2.20% semi-annual payment, 2.19% quarter-annual payment, and 2.19% monthly payment.

If the interest rate in an intra-family loan uses these rates (and the relevant payment terms), there is no implied gift and thus no gift tax to worry about.

Type of Loans Covered: IRC 7872 applies to any transaction that is (i) a bona fide loan; (ii) that is below-market; (iii) that falls within one of four categories of below-market loans; and (iv) does not qualify for one of several exceptions described in that Tax Code section. The four categories of loans that are covered by IRC 7872 include:

  • Loans from a donor (lender) to a donee (borrower), i.e. the conventional intra-family loan transaction;
  • Loans from an employer to an employee;
  • Loans from a corporation to a shareholder; and
  • Loans with interest arrangements that for tax avoidance purposes. [IRC 7872(c) and IRC 7872(a) (1).]

Demand Loans: A below-market demand loan, practically speaking, consists of a two-step transaction. First, the lender is treated as having transferred to the borrower on the last day of the calendar year an amount that is equal to the forgone interest on the loan, which is the prevailing AFR rate (on the date that the loan is made) less the loan’s actual interest rate. Second, the borrower is then treated as transferring that same amount back to the lender as imputed interest income.

Sale Transactions: An imputed gift can also arise with the use of a below-market interest rate and an installment sale, such as a sale to a grantor trust in exchange for an installment note that bears interest until the note is fully paid. If the interest rate on the installment note is ‘too low’, the grantor will be treated as making a taxable gift to the grantor trust.

Original Discount Rules: If the loan provides for the interest to accrue and not be paid for a period, then the original issue discount (OID) rules will apply to the transaction. The OID rules do not apply merely because interest that is to be paid currently is actually not paid by the borrower. The OID rules only apply where there is accrual/deferral of interest by the terms of the loan. The OID rules require the individual lender to report a pro rata amount of the overall amount of the OID calculated amount over the life of the loan using a ‘constant yield method.’ [IRC 1272.] Note, however, in the situation where the interest rate accrual arises in the sale of assets to a grantor trust,  there should be no OID complications so long as the grantor trust classification stays in place, inasmuch as the grantor is treated as entering into a transaction with himself, i.e. the grantor trust.

Frazee: A few years after IRC 7872 was adopted, the Tax Court had the opportunity to determine whether IRC 7872 applied to a transaction, or yet another Tax Code section, IRC 487(e), which would have required the use of a 6% interest rate. The transaction was an intra-family sale of real property. Because the transaction was an intra-family sale and not a bona fide arm’s-length transaction “free of donative intent” the Tax Court held that the excess interest charged on the face amount of the note, i.e. 7% interest, over its recomputed present value using the prevailing AFR rate for long-term loans, constituted a gift of interest by the seller to the buyer. In short, by using the IRC 7872 rate, and not the IRC 487(e) rate, which was then higher, the seller was deemed to have made a larger gift in the form of forgone interest on the sale of the real estate to the family member. Frazee v. Commissioner, 98 Tax Court 554 (1992).

  • Example: Assume a 65-year-old Owen just sold his business. The purchase price was $5.0 million, and after taxes and costs of sale, Owen has $3.5 million in cash. Owen also has about $4.0 million in his profit sharing/401(k) account that he rolled over to his IRA after the business’ sale. Owen also wants to delay taking his social security retirement benefit until age 70 in order to increase that lifetime benefit by 32% (15% of which is ‘tax-free.’). Owen could spend some of the $3.5 million until he attains age 70 ½ and begins to take required minimum distributions (RMD) from his IRA account. Instead, Owen decides to loan $1.0 million to each of his two daughters, who are stay-at-home mothers, this month for a period of 7 years. Owen’s plan is to spend-down his IRA over the next 6 years, taking about $300,000 each year [and not deplete his after-tax sales proceeds capital], so that when Owen is required to begin to take his RMD’s, the balance of his IRA account will be substantially less. Owen does not need the income that generated by the $2.0 million that he loans to his daughters. With 7 year notes given by his daughters, with annual interest payments made by each daughter on her $1.0 million loan to Owen, the interest rate will be 2.21% on each $1.0 million loan, or $22,100. If Owen’s daughter invests the loan proceeds and earns an annual 6% return on those investments, which are used to secure the daughter’s loan to Owen, the daughter’s income from the investment will be $60,000, less the $22,100 interest she paid to Owen, or a net of $37,900. While Owen will be in the 37% tax bracket, with probably another 3.8% Medicare surtax tacked on, Owen’s daughter will probably be in a much lower income tax bracket. After 7 years, Owen can either call the loans, or forgive some or all of the loans outstanding, depending upon his needs and the tax laws at that point in time. All that is required to implement this strategy is two promissory notes and a pledge agreement using the daughters’ investment portfolios as collateral security.

Conclusion: Estate planning these days is all about income tax savings, with far less emphasis on estate tax savings. In light of the current large spread in the federal income tax rates, i.e. from 10% up to 37%, added to which might be the 3.8% Medicare surtax, individuals who are in high marginal federal income tax brackets should closely look at low interest loans to family members who are in much lower, or no, federal income tax brackets, to shift that taxable income to lower income taxes.