Family members who weather this pandemic may consider making a low interest loan to family members with fewer resources. Intrafamily loans have many advantages. The minimum interest rate required by the IRS on intrafamily loans is lower than commercially available rates. The November 2020 IRS rate for a short-term loan (less than 3 years) is only 0.13%! A family lender will require much less disclosure (if any) or collateral than a commercial lender. If the borrower uses loaned funds for an investment and the investment appreciates at a rate greater than the loan interest rate, the excess appreciation remains with the borrower at no gift tax cost.
Loan proceeds can come from an individual’s funds or from a trust. For instance, if the borrower or the family has a trust, the family may want to make the loan from the trust, rather than from personal funds. Unlike a personal loan, though, a trustee owes fiduciary duties to all trust beneficiaries, including managing trust assets with prudence and impartiality. Only if the trust document allows loans to beneficiaries can the Trustee make a loan to a beneficiary. For trusts signed after January 1, 2020, the Connecticut Uniform Trust Code C.G.S. §45a-499nnn(18) allows loans out of trust property to beneficiaries on terms and conditions the Trustee considers to be fair and reasonable. The trustee retains a lien on future distributions for repayment of the loan.
Whomever makes the loan, an individual or a trust, the lender must consider the ability of the borrower to repay the loan. If the borrower does not have the income to repay the loan, the individual lender may regret making the loan. The Trustee, as lender, may worry about a breach of fiduciary duty because the loan will reduce the trust’s assets and could upset other beneficiaries on the grounds of fairness. Certainly, taking collateral for the loan could reduce the chance of loss on the loan.
The loan must not look like a gift or a trust distribution. The goal is to make the loan appear as an investment. Thus, a loan should be approached like any other investment.
If the loan is not properly secured or bears below-market interest, the loan may breach a trustee’s fiduciary duty. The Trustee should disclose the loan to all beneficiaries. An individual lender may consider disclosing the loan to all family members who may be affected if the loan goes unpaid. Best of all would be to get a written letter waiving objection from the affected beneficiaries or family members.
Proper documentation of the loan can avoid misunderstandings and disputes. The family borrower should sign a promissory note. If real estate is taken as collateral for the loan, the borrower should sign a mortgage. If the borrower pledges business assets as collateral, the borrower should sign a security agreement and a UCC financing statement. The lender should file the UCC financing statement with the Connecticut Secretary of State’s Office. If the borrower expects an inheritance, consider making the maturity date of the loan the earlier of the loan term or the death of the person who will provide the inheritance.
The lender must determine the appropriate interest rate. Internal Revenue Code Section 7872 imposes a minimum interest rate called the Applicable Federal Rate (AFR). AFRs are set every month and depend on the term of the loan. The November 2020 AFR for a loan of 10 years or more is 1.17%; the November 2020 AFR for a loan more than 3 years but less than 10 years is only 0.39%. A term loan has a fixed rate for the term of the loan, thus making for a more desirable type of loan than demand loans. The minimum AFR rules apply to loans by trusts as well as by individuals. If the interest rate charged on a loan is below the AFR for the loan, the IRS will charge the interest to the lender and impose tax on the interest at the lender’s tax rate.
Charging a higher interest rate than the minimum AFR may make sense if the lender must consider fairness to other family members or to other trust beneficiaries. For instance, a home loan might bear interest at the 30-year fixed mortgage rate (about 3%), or a business loan might bear interest at the current rate charged by local commercial banks (about 7%). If the lender seeks to preserve invested assets, the going corporate bond rate (about 2.3%) may make sense.
The lender must also determine how to structure the loan. Ideally, the loan amount plus interest will be amortized over the life of the loan. Loan amortization websites like https://www.amortization-calc.com/ make this task easy. For a start-up business loan, the family lender may allow interest only payments for a few years and start the amortization after the initial term has passed.
Intrafamily loans can provide funds to family members who need it most. Providing a loan instead of a gift can preserve self-respect for a family member borrower during a tough time. If you or a family member need assistance in documenting a family loan, give the estate planning attorneys at Cipparone & Zaccaro, PC a call.
November 2020, Issue #29
