Loans can be a great idea for parents who want to give their children a boost for buying a home or starting a business and who have the assets — just watch how you structure these deals.
Formal agreements known as intra-family loans are seeing a resurgence amid low interest rates these days. The intra-family loan allows for some transfer of wealth to take place between generations without using up the lender's lifetime gift tax exemption, which is now at $5.43 million for 2015. Meanwhile, borrowers are subject to annual interest rates as low as 0.40%, based on the length of the loan.
“It's a nice way to leverage cash from the older generation,” said Gavin Morrissey, senior vice president of wealth management at Commonwealth Financial Network. “I see parents giving a child a loan to buy a home or start a business.”
At the end of 2014, Mr. Morrissey helped an adviser structure such a deal for a family that had about $17 million in net worth. The parents already structured plans for their gift and estate tax exemptions that would use both of those exemptions up, but their two adult sons wanted to open up a business that imported technology hardware.
The parents loaned their sons $180,000 in a midterm intra-family loan to jump start the business, with an interest rate of about 1.9% — the rate for these loans
last November — and they did it without having to disrupt their plans for their gift and estate tax exemptions, Mr. Morrissey said.
But these loans aren't easy to put together, and those who aren't careful will attract the attention of the IRS.
“Theoretically, you can draft the note yourself, but if you needed two people to be on your [adviser] team, you'd want an attorney to draft the note and an accountant to make sure they know what's going on,” said Charles V. Douglas, editor of the National Association of Estate Planners and Councils' Journal of Estate and Tax Planning.
WEALTH TRANSFER
The strategy was much more popular as a wealth transfer device when the estate tax exemption was very low, according to Bruce Steiner, an attorney at Kleinberg Kaplan Wolff & Cohen. “You had lots of people who, in the context of a $5 million exemption, didn't seem super-wealthy but were going to be subject to estate taxes, and there were many more people looking to do these [loans].”
Nowadays, it's a boost for borrowers.
To give you an idea of the favorable interest rates for borrowers of intra-family loans: The IRS currently has the
key applicable federal rate at an annual compounding rate as low as 0.40% for short-term loans with a term of up to three years, 1.47% for midterm loans that span three to nine years, and 2.19% for loans that stretch beyond nine years.
Consider a scenario where a client's adult child is weighing a
15-year fixed-rate mortgage to the tune of 3.16% in annual interest, versus a 15-year intra-family loan from mom and dad at a rate of 2.19% per year. It's clear which option is the most attractive to the borrower.
“It's better than having your child borrow from the bank,” said John J. Voltaggio, managing director and senior wealth adviser at Northern Trust Corp.
But don't mistake this as a wealth giveaway to the younger generation. In order to construct a legitimate intra-family loan that will stand up to IRS scrutiny, advisers will need to bring in legal and tax expertise to consult on the deal.
In order to avoid having the IRS contest the loan, clients need to have a promissory note, create a fixed repayment schedule, set a rate that's either at or above the AFR in effect, secure the debt and demand repayment, according to Mr. Douglas.
Clients should also keep records that reflect that this is a true loan, and borrowers need to make timely repayments and must remain solvent, he added.
Lenders must avoid loan forgiveness and hold borrowers responsible for repaying the amount. “If I make a loan and then three months later I tell you not to pay me back, the IRS will say that from the beginning it was clear that this loan didn't have to be repaid, then this is a gift,” Mr. Douglas said.
TAX IMPLICATIONS
There are nasty tax consequences for scenarios where the IRS will consider the loan a gift.
If a loan ends up being viewed as a gift by the IRS, it will require the borrower to either use his or her gift tax exemption or pay out gift taxes, currently at a top rate of 40%.
Forgiveness of the loan, on the other hand, is painful for the borrower. He or she is on the hook for income taxes on the amount forgiven, noted Mr. Morrissey.
Borrowers need to demonstrate that they can repay the loan, which can be hard if they're funding a business that has a hard time generating cash flow in the first few years. Lenders can help head that off by structuring the loan to permit balloon payments. In the slim first years of a new business, a borrower can make interest-only payments with larger balloon payments on the back end to go toward principal, Mr. Morrissey said.
Further, lenders who are receiving interest payments must report it, as it's taxable to them.
For borrowers who are buying a home, there's the benefit of having deductible mortgage interest on the loan.
At the end of the day, well-to-do clients are teaching a life lesson to their children.
“[Parents] are passing on the value of learning what it is to have skin in the game,” said Mr. Voltaggio.
