Family Loans
If you’re interested in lending money to your children or other family members, it’s best to know the rules. Loans can provide generous assistance to someone in need, or they may be a strategic tax planning tool. With a loan, you expect repayment- either over a period of time, or possibly as a lump sum in the future (including from an anticipated inheritance).
Lending can also be an effective way to provide your family financial assistance without triggering unwanted gift taxes. So long as a loan is structured in a manner similar to an arm’s-length loan between unrelated parties, it won’t be treated as a taxable gift. This means, among other things:
- Documenting the loan with a signed Promissory Note,
- Charging interest at or above the applicable federal rate,
- Establishing a fixed repayment schedule, and
- Ensuring that the borrower has a reasonable prospect of repaying the loan.
Even if tax savings isn’t a concern, intrafamily loans offer important benefits. For example, they allow you to help your family financially without depleting your wealth or creating a sense of entitlement. Done correctly, these loans can promote accountability and help cultivate the younger generation’s entrepreneurial capabilities by providing financing to start a business.
Too often, however, people lend money to family members with little planning or regard for potential unintended consequences. Rash lending decisions can lead to misunderstandings, hurt feelings, conflicts among family members and false expectations.
Know the “imputed” interest rules
To be helpful, you may be tempted to charge no interest, but you should resist the temptation. When you make an interest-free loan to someone, you will be subject to “below market interest rules”. IRS rules state that you need to calculate imaginary interest payments as if made by the borrower. These imaginary interest “payments” are then reported as paid to you and you will need to pay taxes on these “imputed” interest payments when you file your income tax return. Further, if the imaginary interest payments exceed $14,000 for the year, there may be adverse gift and estate tax consequences.
Exception: The IRS lets you ignore the rules for small loans ($10,000 or less), as long as the aggregate loan amounts to a single borrower total less than $10,000 and the borrower doesn’t use the loan proceeds to buy or carry income-producing assets.
In addition, if you charge interest below market rate, the IRS might consider part of your loan a taxable gift, especially if there is no formal documentation (i.e. written agreement with payment schedule). As long as you charge an interest rate that is at least equal to the applicable federal rate (AFR) approved by the Internal Revenue Service, you can avoid tax complications and unfavorable tax consequences.
Make loans through a “family bank”
One option is to establish a “family bank.” These entities enhance the benefits of intrafamily loans, while minimizing unintended consequences.
A family bank is a family-owned, family-funded entity — such as a dynasty trust, a family limited partnership or a combination of the two — designed for the sole purpose of making intrafamily loans. Often, family banks are able to make financing available to family members who might have difficulty obtaining a loan from a bank or other traditional funding sources or to lend at more favorable terms.
By “professionalizing” family lending activities, a family bank can preserve the tax-saving power of intrafamily loans while minimizing negative consequences. The key to avoiding family conflicts and resentment is to build a strong family governance structure that promotes communication, group decision making and transparency. Establishing clear guidelines regarding the types of loans the family bank is authorized to make — and allowing all family members to participate in the decision-making process — ensures that family members are treated fairly and avoids false expectations.
Contact us to learn more about the ins and outs of intrafamily lending.