The current low interest rates provide several strategic financial and wealth transfer planning opportunities. Refinancing your home mortgage is clearly the most obvious opportunity, but let's explore others.
Family Loans. You may lend money to a family member (such as a child), and that loan will not constitute a gift to that child if adequate interest is charged. If that child invests the money and earns a better return than the interest charged, that excess passes to the child free of estate and gift tax.
Alternatively, you may sell a valuable asset (such as a business interest) to a child on the installment payment plan, and the purchase price may be discounted if a fractional interest is sold. The leveraging effect of the discount and the low interest rate can be significant.
Sale to a Grantor Trust. Besides making a direct sale to a child, you may sell your closely held business interest to an irrevocable grantor trust created for the benefit of that child. In this transaction, the trust purchases your business interest in exchange for a promissory note. If structured properly, this strategy allows you to fix the value of your stock for estate tax purposes while allowing the growth and value to pass onto your younger family members without losing control.
During your lifetime, there are no income tax consequences related to the sale because the sale is disregarded – you and your grantor trust are deemed to be a single taxpayer. No capital gain or loss on the sale is recognized. Interest payments made result in no income recognition to you. The asset sold to the trust, however, receives no step-up in basis due to the sale. By back-end loading installment payments through the use of a balloon payment, the trust may be further leveraged because the assets that would otherwise be used to pay the installment note are retained in trust and leveraged to maximize growth and income within the trust. The trust uses the available cash flow from the business interest to service the note.
Determining the Interest Rate. Any intra-family loan transaction that uses the “applicable federal rate” for the interest charged will not be treated as a partial gift, thereby allowing both the family lender and borrower to escape adverse gift and income tax consequences.
Every month, the Internal Revenue Service computes and publishes the applicable rate tables. Essentially, there are three rates: a short-term rate, a mid-term rate, and a long-term rate. Which rate applies depends upon the length of the loan. The short-term rate applies to loans less than three years. The mid-term rate applies to loans between three and nine years. The long-term rate applies to loans longer than nine years. Each rate varies slightly depending on whether payments are paid annually, semi-annually, quarterly or monthly. Generally, the longer the term the higher the interest rate will be. For September, the annual short-term rate is 0.26%, the mid-term rate 1.63%, and the long-term rate 3.57%.
For most intra-family loan transactions the term will be between three and nine years, meaning that the mid-term rate applies. Typically, that term will allow the borrower (usually the child or the child's trust) sufficient time to repay the family lender (usually the parent or grandparent).
Summary. Intra-family loan transactions are an effective way to transfer wealth down a generation with no gift tax cost. Additionally, these planning strategies are quite straightforward and simple. Most of them involve a simple written promissory note. If your family may benefit from such loan transactions, please contact us.