The aftermath of the pandemic, cybersecurity attacks and growing hatred and violence in our communities result in many families struggling to stay afloat – financially and mentally. Millions of Americans remain unemployed while small businesses struggle to find workers. Our workforce is completely off kilter, leaving many facing uncertain futures. Can an intra-family loan from wealthy, more stable family members help the situation?
The estate planning technique of an intra-family loan capitalizes on the current low interest rate environment. The loans can be structured in various ways allowing for flexibility of terms that can help both the lender and the borrower. For example, a parent will transfer money to an adult child in the form of a loan evidenced by a note that lays out the terms for repayment. This may be done outright or via a trust.
The terms must charge, at a minimum, interest at the annual federal rate (AFR) in order for the IRS to consider it a loan and not a gift, which may be subject to gift tax. In order for the intra-family loan to keep that characterization by IRS standards, it should be as formal as possible. The terms should be in writing and proper bookkeeping kept of loan payments, interest accrued and any “forgiveness” of debts (this should be done carefully and not above the total gifting limits).
Be Wary of Forgiving Intra-Family Loans
One of the biggest drawbacks to an intra-family loan is that it is not an arms-length transaction. You are dealing with family members who likely care deeply for one another. If the borrower falls on hard times, the family member lender will be more likely to try to amend the loan agreement and offer some type of assistance through loan forgiveness. This may have serious tax consequences if not done properly.
A recent case involved a mother who set up a loan for her son. He had a struggling business and for many years asked her to waive his loan repayments. She agreed. After she passed away, the executor of her estate refused to value the son’s debt as a zero balance and litigation ensued to determined whether the money she lent to him was truly a loan or whether it should be viewed as an advance on his inheritance.
The IRS audited the mother’s estate tax return and issued a notice of deficiency. The IRS argued that the loans made to the son over the years should be recharacterized as gifts and her tax liability adjusted to reflect that recharacterization.
The Court began by reviewing the “traditional factors” used to decide whether an advance was a loan or a gift. Those factors are as follows: (1) there was a promissory note or other evidence of indebtedness, (2) interest was charged, (3) there was security or collateral, (4) there was a fixed maturity date, (5) a demand for repayment was made, (6) actual repayment was made, (7) the debtor had the ability to repay, (8) records maintained by the creditor and/or the debtor reflected the transaction as a loan, and (9) the manner in which the transaction was reported for federal tax purposes was consistent with its status as a loan.
To avoid the situation above, it is important to structure an intra-family loan to align with those traditional factors considered by the court. If you have a family member suffering during these trying times and you are considering providing an intra-family loan, contact our estate planning attorneys for assistance in structuring it properly. They will also help you understand the tax implications and how it may fit in with your overall estate plan. You can schedule an appointment by calling us at (443) 470-3599 or emailing us at office@stoufferlegal.com
