One of the best strategies for clients with wealth is to find ways to maximize the value and economic efficiency of that weath in a way that benefits the family without increasing the tax impact on the client's estate. An intrafamily loan is often an excellent strategy.
Loans to the children and grandchildren can be used to help the kids purchase a home, pay for living expenses, start a business, and many other things. With short term interest rates less than .25% per year, even loaning funds for investment purposes can be an excellent freezing technique for the client's estate.
Here are 5 tips to avoiding traps when making an intrafamily loan.
1. Always Have the Loan in Writing
The importance of making the loan in writing cannot be overstated. How do you prove to the IRS what the terms of the loan were? What if someone dies before repayment of the loan? Who gets the future income and payments? Will other family members be upset that one child got “free” money that they didn't get? If you need to prove that the loan was a bona fide loan and not a gift (very important for tax purposes) you will need documentation to prove it.
2. Take Advantage of the Annual Gift Tax Exclusion
Every year, a client can give $13,000 to as many different individuals as they wish. If the client is married, the couple may give a combined $26,000 per year. If there is a loan outstanding, the client could potentially forgive the annual exclusion amount of the loan each year until it is paid off. This is often preferable to an outright gift that use up exemption and may create negative tax consequences. However, be careful not to merely “loan” the money and then never expect repayment because of future forgiveness of the annual exclusion amounts. This may impact whether or not you actually make a bona fide loan in the first place. You will want to work with a qualified attorney to help avoid that pitfall.
3. Show That You Intended to Collect the Loan
This follows from the comment above. You must have every intention of collecting according to the terms of the loan. I think it is important to have some repayment history on the loan.
4. What if the Loan is in Default
It is not appropriate to let a loan linger in default. This goes towards whether or not you have a bona fide loan. Some attempt at collecting should be made. If the loan is secured, for example, against a house, you will need to consider whether or not foreclosure is appropriate.
5. Charge Interest on the Loan
The Treasury Regulations require that interest be paid on the loan at the Applicable Federal Rate (AFR). The AFR is divided into Short Term (up to 3 years), Mid-Term (3 to 9 years), and Long Term (over 9 years) interest rates. In any intrafamily loan, you must charge at least the appropriate interest rate. In most cases this interest is taxable income to the client and should be reported on their 1040 income tax return. Even if the interest is not paid or is forgiven as a gift, the interest income is still reportable taxable income.