Loans among family members, especially from parents to children, have recently become a more popular estate planning strategy due to the current low interest rate environment, which makes intra-family loans a valuable tool for both lenders and borrowers.  Lenders won’t have large amounts of taxable interest income to report, and borrowers may have lower interest rates under the Applicable Federal Rates, as explained below.  While intra-family loans are indeed important tools in the broad array of estate planning strategies available to families to transfer wealth to the next generation, most clients are not aware of the tax implications surrounding such loans.  It is important that clients understand that charging an adequate interest rate is only one of the many factors that determine whether an intra-family loan will be respected as a bona fide debt.  The Internal Revenue Service (“IRS”) may re-characterize an intra-family loan as a disguised gift subject to gift taxation if the form and/or substance of such loan is not respected.   

A recent case, Todd, T.C. Memo 2011-123, enunciates some of the more important planning points for all tax advisors and their clients to consider.   Although Todd did not involve an intra-family loan, it did provide a thorough analysis of the seven factors that every client should know about and consider when entering into an intra-family loan.

The seven factors are:    

  1. Whether the promise to repay was evidenced by a note or other instrument.

When entering into an intra-family loan, the parties should contemporaneously memorialize the transaction as debt by a ‘promissory note’ when the money is distributed to borrower.  However, keep in mind that written evidence of a promissory note is only one factor in determining a debtor-creditor relationship, and more importantly, the parties must adhere to the terms of the promissory note or the written instrument that governs the transaction.

  1. Whether interest was charged.

The courts have indicated that charging a reasonable rate of interest suggests a bona fide loan.  Each month, the IRS publishes a set of base interest rates called the “Applicable Federal Rates” (“AFR”) that are used for various purposes under the Internal Revenue Code (“IRC”), including the calculation of imputed interest on below market loans between family members.  Therefore, it might be safer for clients charge an interest at a rate that either meets or exceeds the applicable AFR.

  1. Whether a fixed schedule of repayment was established.

A fixed maturity date and a schedule for principal and interest repayment suggests a bona fide loan transaction.   Demand loans – i.e., those loans on which you can demand payment at any time – are trickier as it is harder to confirm the parties’ intent that the advance be repaid.  The IRC and the Regulations thereunder require that the parties to the transaction update the interest rate on a demand note every six months.  As a practical matter, with interest rates currently so low (Midterm AFR for October 2011 is 1.19%), it is probably advisable to avoid demand loans altogether and lock in a low interest rate by structuring the loan as a term note with (i) a fixed maturity date and regularly scheduled principal and interest repayment or (ii) interest only payments with the remaining balance due upon maturity of the promissory note.  In either case, the parties should have written evidence of actual payments made either pursuant to the payment schedule provided under the promissory note or otherwise pursuant to a demand from the lender.

  1. Whether collateral was given to secure payment.

Adequate security is a strong factor in favor of finding a bona fide debt.  While intra-family loans generally do not include collateral, for certain larger intra-family loans with a longer maturity date, it is recommended that the lender consider getting a security interest.     

  1. Whether the borrower had a reasonable prospect of repaying the loan and whether the lender had reasonable expectation of repayment.

The lender should have a reasonable expectation of repayment at the time the funds are advanced for there to be a bona fide loan transaction.  Thus, the lender (usually a parent or a grandparent) should consider the borrower’s (usually a child or grandchild) earning potential, his or her net worth and other sources of income to determine if it is reasonable that the lender would be repaid pursuant to the terms of the promissory note.

  1. Whether repayments were made.

Actual payments pursuant to the terms of the promissory note signify a bona fide loan.  In addition to documenting the loan in writing, the parties should have written evidence of actual payments made under the promissory note.  In the event the borrower fails to make the required payments, the lender should consider attempts to collect the amount owed or any portion thereof after the borrower defaults.

  1. Whether the parties conducted themselves as if the transaction were a loan.

Finally, the parties should generally conduct themselves as if the transaction were a loan.  Therefore, it may not be enough to execute a promissory note, the terms of which neither party strictly follows.  This is even more important if the borrower’s payments under the note are intermittent and the lender plans to forgive some or all of the interest or principal payments using his or her $13,000 annual exclusion gift ($26,000 if your spouse agrees).  The lender may risk appearing as if he or she is not serious about being repaid and the loan may be construed as a disguised gift.  Thus, if the parties elect to use the annual exclusion amount to forgive regular principal and interest payments, proper documentation of the loan, any payments made on the loan and/or the parties’ decision to forgive one or more payments is very important.     

Clients need to be sure of the importance of careful adherence to the agreed terms of the loan arrangement.  The court in Todd held that the distribution was a taxable distribution and not a bona fide debt.  The court explained that the parties did not conduct themselves in a manner sufficient to suggest a debtor-creditor relationship.  In particular, the court noted that (1) interest rate charged on the note was below market interest; (2) borrower failed to make quarterly payments required under the note; (3) lender/trustee did not make an attempt to collect on the defaulted loan; and (4) the promissory note was executed as an afterthought to the transaction, some six months after the funds were advanced.

CONCLUSION

Thus, the moral to this planning strategy is that adequate documentation alone may not be enough to establish a bona fide debtor-creditor relationship; rather, the actions of the parties generally are more important.  A client should assume that Intra-family transactions are likely to attract close scrutiny from the IRS.  Thus, for the IRS to respect the loan and not re-characterize it as an implied gift, you need to respect the loan.

In short, the formalities of the loan must be taken seriously to avoid the loan being construed as a disguised gift, notwithstanding your loan documents.