5 tips for safe intrafamily loans

If a relative needs financial help, offering an intrafamily loan might seem like a good idea. But if not properly executed, such loans can carry negative tax consequences — such as unexpected taxable income, gift tax or both. Here are five tips to help avoid any unwelcome tax surprises:

1.     Create a paper trail. In general, to avoid undesirable tax consequences, you need to be able to show that the loan was bona fide. To do so, document evidence of:

·      The amount and terms of the debt,

·      Interest charged,

·      Fixed repayment schedules,

·      Collateral,

·      Demands for repayment, and

·      The borrower’s solvency at the time of the loan.

Be sure to make your intentions clear — and help avoid loan-related misunderstandings — by also documenting the loan payments received.

2.     Demonstrate an intention to collect. Even if you think you may eventually forgive the loan, ensure the borrower makes at least a few payments. By having some repayment history, you’ll make it harder for the IRS to argue that the loan was really an outright gift. And if a would-be borrower has no realistic chance of repaying a loan, don’t make it. If you’re audited, the IRS is sure to treat such a loan as a gift.

3.     Charge interest if the loan exceeds $10,000. If you lend more than $10,000 to a relative, charge at least the applicable federal interest rate (AFR). Be aware that interest on the loan will be taxable income to you. If no or below-AFR interest is charged, taxable interest is calculated under the complicated below-market-rate loan rules. In addition, all of the forgone interest over the term of the loan may have to be treated as a gift in the year the loan is made. This will increase your chances of having to use some of your lifetime exemption.

4.     Use the annual gift tax exclusion. If you want to, say, help your daughter buy a house but don’t want to use up any of your lifetime gift and estate tax exemption, you can make the loan and charge interest and then forgive the interest, the principal payments or both each year under the annual gift tax exclusion. For 2020, you can forgive up to $15,000 per borrower ($30,000 if your spouse joins in the gift) without paying gift taxes or using any of your lifetime exemption. But you will still have interest income in the year of forgiveness.

5.     Forgive or file suit. If an intrafamily loan that you intended to collect is in default, don’t let it sit too long. To prove this was a legitimate loan that soured, you’ll need to take appropriate legal steps toward collection. If you know you’ll never collect and don’t want to file suit, begin forgiving the loan using the annual gift tax exclusion, if possible.

© 2020

Family business owners must weave together succession and estate planning

It’s been estimated that there are roughly 5 million family-owned businesses in the United States. Annually, these companies make substantial contributions to both employment figures and the gross domestic product. If you own a family business, one important issue to address is how to best weave together your succession plan with your estate plan.

Rise to the challenge

Transferring ownership of a family business is often difficult because of the distinction between ownership and management succession. From an estate planning perspective, transferring assets to the younger generation as early as possible allows you to remove future appreciation from your estate, minimizing any estate taxes. However, you may not be ready to hand over control of your business or you may feel that your children aren’t yet ready to run the company.

There are various ways to address this quandary. You could set up a family limited partnership, transfer nonvoting stock to heirs or establish an employee stock ownership plan.

Another reason to separate ownership and management succession is to deal with family members who aren’t involved in the business. Providing such heirs with nonvoting stock or other equity interests that don’t confer control can be an effective way to share the wealth with them while allowing those who work in the business to take over management.

Consider an installment sale

An additional challenge to family businesses is that older and younger generations may have conflicting financial needs. Fortunately, strategies are available to generate cash flow for the owner while minimizing the burden on the next generation.

For example, consider an installment sale. These transactions provide liquidity for the owner while improving the chances that the younger generation’s purchase can be funded by cash flows from the business. Plus, so long as the price and terms are comparable to arm’s-length transactions between unrelated parties, the sale shouldn’t trigger gift or estate taxes.

Explore trust types

Or, you might want to create a trust. By transferring business interests to a grantor retained annuity trust (GRAT), for instance, the owner obtains a variety of gift and estate tax benefits (provided he or she survives the trust term) while enjoying a fixed income stream for a period of years. At the end of the term, the business is transferred to the owner’s children or other beneficiaries. GRATs are typically designed to be gift-tax-free.

There are other options as well, such as an installment sale to an intentionally defective grantor trust (IDGT). Essentially a properly structured IDGT allows an owner to sell the business on a tax-advantaged basis while enjoying an income stream and retaining control during the trust term. Once the installment payments are complete, the business passes to the owner’s beneficiaries free of gift taxes.

Protect your legacy

Family-owned businesses play an important role in the U.S. economy. We can help you integrate your succession plan with your estate plan to protect both the company itself and your financial legacy.

© 2020