The Advantages of Intra-Family Lending
With the anticipated transfer of the most significant wealth from one generation to the next in the coming years, and many families finding their children and/or grandchildren or other family members struggling under the current economic situation, those individuals who have sufficient means should consider family loans in addition to gifting. Some professionals refer to this planning technique as the family bank or family loans depending on whether the loans are directly from the parents or other individuals or through a trust or other entity. Lending money to younger generations is an effective estate planning tool.
Lending has a number of benefits over gifting for many families, especially if the lender has used all of his or her federal estate/gift tax credit. A key advantage is the ability to provide financial assistance to children and others without gift tax consequences. If the loan is structured as an arms-length loan, as would exist between unrelated parties, it will not be treated as a taxable gift. As with many planning tools, the loans must be properly documented with a Promissory Note, charging interest at or above the applicable federal rate (AFR), provide for a repayment schedule and based on recent case law, for the interest to be deductible, the loan must be secured by a recorded mortgage.
Even if gift and/or estate taxes are not a concern, intra-family loans offer important benefits. For example, they allow this lender to help others financially without depleting his or her wealth or creating a sense of entitlement. In addition, the borrower often invests the loaned funds so that the growth exceeds the interest due, therefore shielding all growth from the lender’s estate. In addition, the borrowers, usually a younger generation, learn fiscal responsibility through the process of making payments, while the lender receives some cash flow via interest or interest and principal payments. These loans can also act as seed capital for the borrower’s entrepreneurial capabilities by providing financing to start a business or other enterprise.
However, too often people lend money to family members with little planning or documentation, resulting in unintended consequences. Loans made without forethought and documentation can lead to misunderstandings, hurt feelings and conflicts among family members when such loans are not properly memorialized and other family members who may not have received loans may feel that they have been mistreated.
In addition to loans from one family member to another, the loans can be made through an entity that practitioners refer to as the “family bank.” This is a family owned entity such as a dynasty trust, family limited partnership or a combination of the two. These are often established for the sole purpose of making intra-family loans. This family entity is 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 rates. For example, as of April, 2014, a loan of 3-9 years could provide for a rate of about 1.81%. This arrangement can also preserve the tax-saving power of intra-family loans while minimizing negative consequences. The key to avoiding family conflicts and resentment is to provide a family governance structure that promotes communication, group decision making and transparency.
We have structured many intra-family loans either directly from one generation to another or by means of an irrevocable trust that could be a dynasty trust existing for multiple generations. However, we and other experts recommend that all such loans be properly documented and all parties understand the interest rate and payments that are required. If you would like to learn more about the benefits of this interesting estate planning tool, please contact George M. Riter, Managing Partner at Timoney Knox, LLP.