How can a wealthy family loan money to family members and grow investment assets outside of their estate? What about loans for other purposes?
How can a wealthy family loan money to family members and grow investment assets outside of their estate? What about loans for other purposes?
One of the most basic planning techniques for wealthy families is making loans at the applicable federal rate to family members or trusts. I once had a family member make a $1 million loan to a newly formed trust for his one-month old, when the applicable federal rate was under 3% for long term loans, and invest it in the S&P. That was in 2011. That was a smart move.
A family member may loan cash, and the borrower may then invest the cash with the expectation of generating a return greater than the interest rate on the loan.
Principal and interest remain payable to the lender. The borrower retains the investment result above that financing cost, and bears the risk that the investment will not earn enough to cover it.
The tax rules begin with whether there is a bona fide loan.
The arrangement needs a real debtor-creditor relationship and an enforceable obligation to repay. The written terms, repayment capacity, payment history and the parties’ conduct should support that relationship. Charging the applicable federal rate does not turn an intended gift into debt.
What Interest Rate Can You Charge?
The IRS publishes rates each month - you are looking for the applicable federal rate (AFR). Any amount below creates imputed interest or a gift.
For almost any loan, so long as the family charges the relatively low applicable federal rates, the loan will be allowed for income and gift tax purposes.
For a term loan, the AFR is generally determined when the loan is made. The appropriate term and compounding convention determine which rate applies.
• Not over three years uses the short-term rate.
• Over three years but not over nine uses the mid-term rate.
• Over nine years uses the long-term rate.
If the loan is below market, interest is imputed on the deemed transfer. For a gift loan, that transfer can have gift-tax consequences.
When you make a intrafamily loan, the lender’s estate still holds the note to the extent it remains outstanding, and the lender receives the interest. The possible wealth transfer comes from the borrower’s investment performance above the financing cost. The debt remains payable even if performance disappoints. Later forgiveness of the obligation is a separate gift question.
Loans involving a trust also require identifying its income-tax owner. A loan between a grantor and that grantor’s wholly owned grantor trust is generally disregarded for income-tax purposes but not for gift tax purposes.
Rates are not low today, so the naked loan as an investment plan is not a good idea today. But intrafamily loans remain a key technique for wealthy families to incorporate in their tax planning.
Follow the Secret Art of Planning newsletter for more tax planning.