No, you read that title correctly. Is anything more fun than an unpaid "intrafamily loan" while the lender and borrower are seated together at the Thanksgiving table?
It is kind of like having a skunk show up at your picnic.
(The "loan" is the skunk, not your freeloading family member.)
My standard advice to parents when "bailing out" an adult child?
If you want to sleep well at night and enjoy family get-togethers and all manner of holidays, regard the transfer as a "gift" rather than a "loan" (at least in your heart).
Fact of Life #17: Some folks have children who become adults and, well, some have children who just get older.
Enough said.
That noted, when does it make "estate planning" sense to make an intrafamily loan?
It seems many wealthy families are leveraging the historically low interest rates by pairing intrafamily loans with trust planning.
A recent Barron’s article, titled “How Family Loans and Trusts Can Create Big Wins,” tells tale of a business owner who used just such a technique.
It seems this gentleman sold his $30 million family limited partnership to a trust he created.
So far, nothing unusual.
However, because tax rules permit illiquid shares in a family partnership to be transferred to a trust at about a 30 percent discount this was a tax-efficient way to transfer the business to his heirs.
But what about gift taxes, Kyle? Even with the discount, the value of the business is way above the federal estate tax exemption in 2009 and today.
Excellent observation.
No gift tax is owed because the transaction is considered a sale.
In return for the sale, the business owner received a note from the trust.
And the note is paying him a few million dollars in the form of interest payments.
This is all detailed in a recent Barron’s article, titled “How Family Loans and Trusts Can Create Big Wins.”
But wait, there is more to the tale.
The note itself has a fixed value.
Consequently, this "froze" the business owner's interest (and his net worth for IRS purposes) and it matters not one whit how much the underlying asset appreciates.
In fact, the "sold" business interest does not need to appreciate much for this intrafamily loan to pay off.
As Paul Harvey would say, here is the rest of the story.
The business is now worth $250 million, and has been growing tax-free inside the trust for his children’s benefit.
What is the payoff in terms of estimated estate taxes if the business owner lives to his actuarial age?
Can you say saving between $40 million and $60 million in estate taxes today, but more than $100 million if he lives to his actuarial age?
The article advises that with low interest rates families with taxable estates can benefit from structured trusts and intrafamily loans.
The rates on intrafamily loans allow parents to lend their children cash at rates far lower than a comparable commercial loan rates. Plus, they can be part of a broader wealth transfer strategy.
Consider this hypothetical example:
An aging millionaire funds a trust with a $100,000 gift for his children. Then, he turns around and loans the trust $900,000 at the allowable 1.82% interest rate for five years.
The trust invests the funds contributed.
Thereafter, according to the loan terms, the trust makes regular payments on the loan and then repays the principal in full at the term’s end.
Result?
Any investment gains over that extremely low interest rate are tax-free in the trust for the next generation.
Sweet.
What about the trust, is there anything special about it?
Good question.
The type of trust used for this planning is called an "intentionally" defective grantor trust.
No, really, that is the name.
Here is how it works.
For starters, such a trust is considered an "irrevocable complex trust" for estate-tax purposes (the assets transferred to it are immediately outside of the trustmaker's estate) and a "grantor trust" for income-tax purposes.
Translation: you get to shift the asset contributed out of your estate for death tax purposes, but you pay income taxes on the earnings inside the trust. Since you are paying the income taxes instead of the trust/your children paying them, this means even more wealth is transferred to your family.
There are always caveats.
In this case make sure the loans are straight up bona fide loans.
No monkey business!
If the IRS deems the loans in form but gifts in substance, then you could owe gift taxes at 40% (but the annual gift-tax exclusion is $14,000, and the lifetime gift-tax exemption is $5.43 million).
Ouch.
Bottom line: dot all of the I's and cross all of the T's with with the proper documents, terms and interest rate.
Payments must be made on time, just like loans made to a stranger.
When you’re planning your wealth transfer, consider a loan and a trust, but do it right with the help of an experienced estate planning attorney.
So, how do you find an "experienced" estate planning attorney?
First, ask around. Friends, family and other professional advisors are trustworthy sources.
Second, conduct an "organic" search on "Google" for "estate planning" near you (e.g., "estate planning your city state").
Third, either way, verify. Check out the education, experience, ratings and client reviews of any attorney before you contact him or her.
How?
There are two helpful resources just a mouse click away to assist with your due diligence: Avvo.com and Lawyers.com.
Check any Avvo ratings, client ratings/testimonials and attorney endorsements on Avvo.com and any "peer ratings" by judges/other attorneys and any client ratings/testimonials on Lawyers.com.
In fact, I use both of these services to thoroughly vett attorneys before referring members of our "client" family for legal help in other areas of law or for matters in jurisdictions outside Kansas or Missouri.
Remember: “An ounce of prevention is worth a pound of cure.” When making your financial, tax and estate plans, do not go it alone. Be sure to engage competent professional counsel.
Reference: Barron’s (September 26, 2015) “How Family Loans and Trusts Can Create Big Wins”
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