Gifts vs loans: don’t be generous at fault
As parents, we often want to help our adult children who are in need of a financial boost. And often this help takes the form of a loan. Loans are an effective and common way for parents to promote their child’s independence, encourage responsibility, and signal their confidence that their child can be successful on their own.
Plus, with today’s historically low interest rates, parents have less interest income to report and children can pay less interest than if they borrowed money from a bank. Unlike freebies, loans don’t use any of your lifetime tax exemptions, which currently stand at an all-time high of $ 11.58 million per person (indexed to inflation).
The case of Mary Bolles
While intra-family loans are important tools that can be used to transfer wealth to the next generation, most parents are unaware that their actions and loan repayment expectations can redefine “loan”. into a taxable “donation”, which has unintended tax consequences on donations. This is exactly what happened to Mary Bolles in the recent case of Estate of Mary P. Bolles v. Comm’r, TC Memo. 2020-71 (June 1, 2020).
Mary, a mother of five, made numerous loans to each of her children and kept meticulous records of every loan and every repayment. Between 1985 and 2007, Mary loaned her son Peter around $ 1.06 million to support his business ventures, although it eventually became clear that he would not a long term be able to repay the loans. In addition, none of the loans made to Peter have ever been formally documented, and Mary has never attempted to enforce collection of any of these loans.
In late 1989, Mary created a revocable living trust, which specifically excluded Peter from any distribution of his estate upon his death. Although she subsequently changed her trust to no longer exclude it, she included a formula to account for the “loans” Peter received to make distributions to his children. After her death, the IRS deemed the total loan amount, plus accrued interest, to be part of her estate. They valued the estate with a tax deficit of $ 1.15 million. The estate took the opposite position, claiming that the entire amount was a gift.
What the Court decided
In its analysis, the court considered certain factors to be considered in deciding whether the advances were loans as opposed to gifts. Noting that the determination depends not only on how the loan was structured and documented, the court noted that in the case of an intra-family loan, a key consideration is whether there was a real expectation of repayment and the intention to assert the debt.
The court ultimately “divided the baby”, ruling that all the pre-1990 advances were in fact loans (totaling over $ 425,000), as the evidence suggested that Mary reasonably expected him to repay the loans. … until he was deprived of his trust at the end of 1989. The court considered the funds given to Peter after his escheat – from 1990 – as gifts.
What anyone considering a loan should remember
The takeaway from this case is that if you plan to take advantage of the high gift tax exemption before it ends, it would be prudent to review all family loan transactions. In progress. You need to determine to what extent these loans may have been turned into freebies over the years, which could negatively impact the amount of your remaining available exemption. The safest way to do this would be to consult a tax professional who can help you navigate these complex rules safely. To be sure, follow these simple steps:
- Document the loan transaction between the lender and the borrower.
- Interest charged based on government rates (AFR) published monthly.
- Make sure that the borrower will have enough equity to repay the loan. Request and keep a copy of the borrower’s financial statements.
- If the loan requires periodic payments, make sure the payments are made on a timely basis.
- Report the interest income you receive from the borrower on your tax return.
Since actions can speak louder than words when family is involved, it is important to remember that you and your family should continue to treat these loans as loans to third parties in order to avoid any unintended consequences of the loss. inheritance tax in the future. Intra-family loans are an advantageous way to transfer wealth from one generation to the next, given the very low interest rate environment. Just make sure you complete the transaction well to avoid any issues down the road.
Managing Partner, Jeffrey M. Verdon Law Group, LLP
Jeffrey M. Verdon, Esq. is the manager of the Jeffrey M. Verdon Law Group, LLP, a law firm specializing in trusts and estates located in Newport Beach, California. With over 30 years of experience designing and implementing comprehensive estate planning and asset protection structures, the law firm serves affluent families and successful business owners to solve their most pressing issues. complexities and the goals and objectives of inheritance tax, income tax and asset protection.