Regina Jaeger, CTFA

Vice President, Senior Trust Relationship Officer

Key to a Successful Family Loan—Document, Document, Document

With interest rates so low, intra-family loans (also referred to as family loans), using current low interest rates, have garnered significant interest for the purpose of wealth transfer to complement a holistic estate plan. While the majority of the conversation in recent years has focused on wealth transfer as the purpose of a family loan, perhaps a more common purpose is to simply help out a family member who is in financial need. When making a loan to a son, daughter, grandchild, or other potential heir, there is no step of greater importance than adequately documenting the transaction from beginning to end to ensure the loan has the intended impact in the context of your overall estate plan and goals.

There have been many cases where the US Tax Court has ruled on whether a loan is actually a gift. The IRS defines a loan as the transfer of property or money to someone else with the expectation that the transfer of property or money will be paid back in some fashion in the future. Consequently, the first document to build upon is the execution of a loan agreement (many times in the form of a promissory note) to memorialize the arrangement, regardless of how short term the loan is expected to last before the money is paid back. The loan agreement should include the loan terms like interest rate, maturity date, interest calculation method, payment structure, default language, etc. The loan agreement is the basic starting point for your family loan documentation file.

Once the loan document is in place, it is equally important to maintain adequate records of payments made, or not made, toward payback of the loan. Unfortunately, there have been far too many instances where a parent has loaned a child money, a promissory note is signed, but adequate repayment records are not maintained, leaving the personal representative or successor trustee of the parents’ estate with possibly conflicting accountings of the outstanding balance of the loan, ultimately causing conflict among heirs. To ensure outstanding family loans are properly handled at the lender’s death, it is essential to maintain detailed payment records. If payments are not made according to the payment scheduled identified in the loan agreement, record of those missed payments are equally important in helping to determine the outstanding loan balance.

In addition to the loan agreement and record of payments made, it is equally important to review how the family loan interplays with your estate planning documents. Meaning, are you as an individual the lender, or are you as the trustee of your revocable living trust the lender? Does your trust document address how the trustee should handle outstanding family loans upon your death? Is the unpaid loan balance treated as an “advancement” of a bequest? Should other beneficiaries be equalized in an amount equal to the outstanding loan balance? Many clients forget to address these questions, which can result in unintended disposition of assets at death and strain on family relationships. For example, assume that you as trustee of your revocable living trust loan your grandson $50,000 toward the purchase of a home. Your intention is that if the loan is not paid in full prior to your death, the outstanding loan balance should be considered as a bequest to your grandson. As of the date of your death, your grandson has made $20,000 in principal payments, as evidenced by the payment records you diligently maintained. The successor trustee turns to your trust document for direction of how the family loan should be treated and finds that your trust does not contain a provision that the outstanding balance should be treated as a bequest to your grandson. As a result, the trustee is required to collect on the loan and it is immediately payable in full. Alternatively, perhaps your trust does contain a provision that the outstanding balance is a bequest to your grandson, but there is no provision contained in your trust that addresses your other grandchildren, which if left silent leads to unintentionally treating your grandchildren unequally. To safeguard against unintended estate distribution results, your estate plan documents should be reviewed, and amended if needed, to assure that outstanding family loans at the time of death will be handled in a manner that is consistent with your intended estate distribution goals.

In most cases, our clients share with us when they have made a loan, or plan to make a loan, to a family member. We then help them through the documentation and estate plan review process. However, unfortunately there have been too many occasions where family loans for a purpose other than wealth transfer have been “discovered” too late, causing problems among family members, distribution of assets contrary to estate plans, and avoidable administrative complexity. To avoid unintended consequences of family loans when helping a son, daughter, grandchild or other heir in need, maintaining adequate documentation of the transaction from beginning to end, and confirming its treatment in the context of your overall estate plan is vital to ensure your intentions are executed efficiently and with desired results.

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