Originally published in Forbes on October 6, 2022
BY: DAVID REDDING, CTFA, AEP, CWS
Austin, TX Market President, Argent Trust Company | (512) 478-3188
Providing intrafamily loans can be a powerful way for families to spread their wealth to children and grandchildren, but they also have the potential to create disharmony and resentment. I’ve seen this planning tool create capital for families and successfully spread wealth to future generations needing a helping hand to generate initial wealth-building. But intrafamily loans can also produce enormous amounts of friction within families if not planned with rigorous and compassionate attention to detail.
In short, these loans should be carefully considered with the help of a professional to navigate the ins and outs of the process and potential pitfalls.
Typical Uses Of Intrafamily Loans
One of the most frequent uses of intrafamily loans is purchasing shares of a family business or partnership. If the business or partnership produces income that is then paid to the indebted child, the liquidity can be used to repay the loan—and the type of arrangement can work very well. Another option would be to gift the business outright to the child or children when considering the high estate tax exemption (currently at $12,060,000 per individual, and $24,129,999 per couple). However, selling the asset using a note can preserve the exclusion for the use of transferring other assets.
The primary consideration when determining if an illiquid asset like a business or partnership should be gifted or sold on a note downstream to successor generations is the cash flow needs of the selling generation—because all income from the entity gifted will be paid to the new owner and not to the gifting/selling generation. If this income is needed to support the parents, then selling the asset makes sense.
The use of a note can do three very positive things. It can create the needed cash flow in the form of note payments back to the selling generation. It can create liquidity for the purchasing generation to make the necessary note payments, and it will set a value for the asset being sold, meaning no additional appreciation in the business or partnership is created in the estate of the sellers—further increasing their taxable estate. It is very important that any business or partnership interest be appraised prior to a gift or a sale via note.
Another prudent use of intrafamily loans is the funding of a mortgage for children or grandchildren. Lower payments can typically be accomplished via an intrafamily loan as opposed to a conventional lender, based on their financial situation.
Intrafamily Loans Have Great Advantages But IRS Terms Must Be Met
The Internal Revenue Service (IRS) is very clear on the terms for an intrafamily loan, and their requirements must be followed carefully, or the note may be considered a gift. To qualify, a minimum interest rate must be applied to the loan, and the IRS has three tiers for rates—short-term (0-3 years), mid-term (3-9 years) and long-term (more than 9 years). The current AFR table can be found on the IRS site. Again, it’s very important to consult the current rates because a rate charged that’s lower than the AFR will be considered a gift by the IRS.
For example, if a 3-year term loan is made to a child, the current short-term rate of 3.05% would apply (as of September 2022). Regardless of the creditworthiness of the borrower, this advantageous interest rate still applies—a child or grandchild with a poor credit score would likely be turned down by a conventional lender or receive a loan with a much higher interest rate. Terms and conditions of intrafamily loans are subject to whatever terms and conditions the lender puts in place—but these loans still must be met with the minimum AFR and consistent payments.
As referenced above, with a current AFR for long-term loans at 3.14% (as of September 2022) and the current national average of around 6% for a 30-year mortgage, this arrangement can save a tremendous amount of money over the life of a loan. Subject to itemization rules, the indebted party can also deduct mortgage interest. The standard deduction may still be lower, but there could be an opportunity for a potential tax break, in addition to a much lower interest rate.
Intrafamily loans also provide opportunities to help pay the loan back. The most straightforward strategy is to provide an annual gift allowance (up to $15,000 to a child or grandchild, or $30,000 to a couple) and then apply gifted money to the borrowed loan amount. The reason this is usually my advice is, when considering any potential future audits, this procedure helps to keep the process clean and easy to authenticate.
In my experience, the biggest strain put on families using intrafamily loans can happen when these loans are provided to one child but not others in the family. There’s a very good chance that this will cause jealousy among siblings or grandchildren and can cause enormous damage to family dynamics and relationships.
Intrafamily loans are a powerful way to spread wealth from one generation to another but should be applied with care—both for the financial considerations and thoughts and feelings of participants.
David E. Redding, Market President and Senior Wealth Advisor at Argent Trust Company, helps clients navigate the complex world of estate planning, trust administration, wealth transfer and closely held business strategies. David has over 28 years of experience in in the wealth management industry.