Many parents make loans to their adult children for a variety of reasons, whether to buy a home or farm, start a business or even to buy a family business or other family asset their child cannot afford on their own. Parents also loan their adult children money when they have fallen on hard times or perhaps lost their job.
While this is true at most times, the COVID-19 crisis has made “intra-family loans,” or loans made between family members, even more common. Staggering unemployment rates and shuttered businesses mean that more adult children may need to call on their parents for financial support, and an intra-family loan could be an attractive option for parents who want to provide short-term assistance for their son or daughter.
If you have already made a loan to one or more of your children, or if you are considering making such a loan, it is important to understand the implications for your estate plans. In this article, we will explain the advantages and disadvantages of intra-family loans, the options for and importance of documenting these loans, and considerations for how to treat of these loans in your estate plans.
The most obvious benefit of providing a loan to your adult child is the cost savings to him or her. With a documented loan to your child, the interest rate only needs to be as high as the applicable federal rate (AFR), which tends to be lower than interest rates for bank loans. In addition, your child will save on the transaction costs and administrative fees associated with institutional lenders. You may also include favorable terms not available with a traditional loan, such as tailored timing of payments, no penalty for prepayment, or even an incentive to pay off the loan early. And of course, if your child would not qualify for a traditional loan, then the intra-family loan would enable him or her to make a purchase that would not otherwise be possible.
However, there are also potential benefits to parents as well. With a documented loan, you would receive added income in the form of interest. Also, if your child does not repay the loan, there is a non-business bad debt deduction available for you to use to reduce your taxes. These loans also could enable you to avoid potential gift tax concerns, as they are not included in those calculations. Plus, unlike a traditional bank loan, an intra-family loan allows you to keep added wealth within your family that would otherwise flow to the bank in the form of interest and fees.
Of course, if you have even heard the phrase, “Never mix business with family,” then you know there are potential risks associated with loaning money to your son or daughter. The most common example is the risk of nonpayment. It would be challenging to recoup the money from your child, especially if he or she made a poor investment or spent it in another unwise manner. And what if your child is late one month, or multiple months? While you could hedge against the risk of late payments by including a penalty, terms in a contract do not guarantee payment of those or the loan itself if he or she is unable to do so.
In addition, there is great risk with loans that are not documented or do not include interest, because so-called “interest-free” loans to your children are not treated as such by the IRS. If you do not include the minimum AFR interest on the loan, then the IRS can impute the interest payments to you. This means that you will have to pay tax on the interest regardless of whether or not your child pays it to you.
A loan to your child can be reflected in a promissory note, a balloon note or a mortgage/deed of trust. A promissory note is a simple “IOU,” or agreement to repay the amount he or she borrowed plus interest. A balloon note is a loan agreement that contains a “balloon,” or sizable payment, toward the end of its term to allow for much lower payments over the course of the loan. A mortgage/deed of trust is an option available when the money loaned is for a home or other property, because it is essentially a loan agreement in which you have the right to take action and receive ownership of the property if your child fails to repay.
For any option, it is recommended that the document contain the following information at a minimum:
- The total amount of the loan
- The purpose of the loan
- The terms for repayment, including interest, timing of payments and the date when the full amount is due
- The total amount due overall, including interest
Also, if you are considering late payment penalties or an incentive for early repayment, then those terms must be included as well.
Although a promissory note may seem like the easiest option, anyone considering loaning money to their adult child would benefit from consulting an experienced attorney to ensure everyone involved understands and is protected against potential fallout from the process. In addition, regardless of which type of loan document you choose, it is critically important to document the loan. As we explain below, failing to do so can have significant implications for your estate plans and potentially cause irreparable harm to family relationships.
The importance of documentation - First, verbal loans are extremely difficult to prove, so if you do not have the proper documentation in place as explained above, the loan likely will not be reflected in your estate distribution. This means that if you have other children who perhaps know or learn about the loan, there could be potential strife between siblings over unequal treatment. Assuming you document the loan, you will want to decide how to be treat the loan in your estate plans. Do you expect that child's inheritance to be reduced as a result? Or, do you instead prefer to treat the loan as forgiven at that point?
Loan as advance on Inheritance - A common approach to consider is treating the loan as an advance on that child's inheritance. In that case, the value of the unpaid portion of the loan will be included in the total value of your estate to be divided between your heirs. Then, the amount due to that child will be reduced by the amount he or she has not yet paid. If you choose this option, you might also consider specifying in the loan document that any loan forgiveness must be in writing to prevent a claim that you verbally forgave the loan.
Loan forgiveness - If instead you do not want the loan to affect your child's inheritance, then you could indicate that the loan is to be forgiven by your estate. Although this might seem preferable in a situation where your other children are better off financially, be aware that this could have unintended consequences. The IRS treats loan forgiveness as a form of income, so it could mean that your child has to pay tax on the amount forgiven by your estate. Or, it could have gift tax implications depending on the size of the loan.
If you have a trust - If your assets are primarily held in trust, it may be advisable to assign the loan payments to the trust instead of receiving them personally for tax purposes. This depends on the kind of trust you have and the terms of the trust document, so legal and financial counsel on this question to would be invaluable for determining what structure is most tax-effective for you.
Probate process - If your primary estate planning document is a will, then any loan to your child will be subject to the probate process. For debts owed to an estate, the personal representative or executor of your estate is charged with collection as part of estate administration. So, to avoid any unnecessary burdens for your child or your personal representative, ensuring that you have clearly outlined your intentions and preferences will be key.