Wednesday, December 23, 2009

Intra-Family Loans and Estate Planning

From a December 23, 2009, Bloomberg article:

Loans at 0.57% to Family Members Could Save Millions on Taxes

By Alexis Leondis and Margaret Collins

Dec. 23 (Bloomberg) -- Estate planner Richard Behrendt helped his client make $5 million loans to each of his children this year, avoiding gift taxes of 45 percent and saving the kids as much as $837,000 apiece in interest.

Rates for so-called intra-family loans have declined as much as 53 percent since 2008. “The timing of it was clearly tied to the rock bottom of these rates,” said Behrendt, who works for Robert W. Baird & Co., based in Milwaukee, Wisconsin.

The loans may be the perfect holiday gift to help relatives this year, according to Carol Kroch, head of wealth and financial planning at Wilmington, Delaware-based Wilmington Trust. For wealthy taxpayers, they can be used for estate planning purposes, since gains earned will be free of estate and gift taxes.

That’s because low interest rates and depressed asset values mean there’s a greater possibility that investments purchased with an intra-family loan, such as stock, will appreciate more than the loan’s cost, Kroch said.

The rate for an intra-family loan made in January 2010 for less than three years is 0.57 percent. The rate is 2.45 percent for a loan of three years to nine years and 4.11 percent for a loan of nine years or more, according to the Internal Revenue Service, which sets the rates monthly. That compares with an average rate of 10.55 percent for a personal bank loan in the New York metro area and 12.51 percent for a credit-union loan, based on data from

“The chances are they are going to go up, the only question is how fast or how soon,” said Bill Fleming, managing director of New York-based PricewaterhouseCoopers’s Private Company Services Group, referring to rates for intra-family loans.

Tax Savings

Behrendt’s client, who has a net worth of $100 million, loaned each of his three children $5 million for nine years. The children invested the money in a balanced portfolio seeking at least a 5 percent return, said Behrendt, a former estate tax attorney for the IRS.

Any amount above the 1.65 interest rate, which was the February rate, should pass to the client’s children free of estate and gift taxes, he said. The Standard & Poor’s 500 Index has increased 36 percent since February as of yesterday.

The borrowers also saved on interest costs because of the low rates. Each will owe $82,500 in interest annually, compared with $175,500 if the loan had been made in February 2008 when the rate was 3.51 percent.

Current federal law taxes estates exceeding $3.5 million for an individual or $7 million for a married couple at as much as 45 percent. Any gift to an individual of more than $13,000 annually may also be taxed as much as 45 percent with a $1 million lifetime exclusion per donor, according to the IRS.

Estate Tax

The estate tax is scheduled to expire for a year on Jan. 1 under the provisions of a tax-cut bill enacted in 2001. It comes back in 2011, taxing estates valued at more than $1 million as much as 55 percent. Senate Finance Committee Chairman Max Baucus, Democrat of Montana, has vowed to extend the estate tax in 2010 retroactively.

Lenders who are subject to the estate tax can use the loans to reduce the value of their estates because the appreciation of any investment made with the loan above the IRS rate accrues outside of the lender’s estate, said Larry Richman, chair of private wealth services at Neal, Gerber & Eisenberg LLP in Chicago.

Taxpayers with family businesses may also want to consider intra-family loans to help with the sale of the business to family members, according to David Kron, a partner in the Fort Lauderdale office of law firm Ruden McClosky.

Parents can loan their children money to buy the business and the children can repay using profits from the firm. The future appreciation and any income of the business beyond the loan amount are then considered part of the children’s, not the parents’, estate, Kron said.

‘Low-Tech’ Tool

Intra-family loans are a “low-tech” way to give money to family members because they’re easy to set up and are appropriate for anyone regardless of net worth, said Deborah L. Jacobs, author of “Estate Planning Smarts: A Practical, User- Friendly, Action-Oriented Guide,” which was published this month.

Family members should be aware the loans must be repaid in full with interest at the rate specified by the IRS. If the borrower doesn’t repay, it may be considered a gift subject to the gift tax, said Jacobs, who is based in New York.

Lenders should also consider the income tax they’ll owe on the interest received with repayment of the loan, said Kron.

‘Thanksgiving Firecracker’

Loaning money to family members may create relationship issues, said Dan Deighan of Melbourne, Florida-based Deighan Financial Advisors Inc.

“It’s like throwing a firecracker on the Thanksgiving dinner table when you bring money issues into the family dynamic,” Deighan said.

Borrowers can get “sloppy with repayments,” which is why setting up an automatic bank transfer for payments is recommended, said Fleming of PricewaterhouseCoopers.

Don Albritton, a 61-year-old executive in Longwood, Florida, gave his son $260,000 to buy a house through a 30-year intra-family loan four years ago. Albritton ended up taking the house back after his son was unable to sell it without taking a loss. Home prices have declined 17 percent since January 2005, according to the S&P/Case-Shiller index for 20 metropolitan areas.

“I’m not discouraged,” Albritton said. “I’m getting ready to make him another loan now.”

Last Updated: December 23, 2009 00:01 EST