Helping loved ones, whether family or friends, can satisfy both benefactor and beneficiary. Successful investors are often approached for financial assistance by less affluent loved ones or younger family members who are just starting their adult lives and careers.

When considering the many ways to put money in the hands of another, it’s important to consider all the options available. Payment for work performed is one common means of transfer. This method provides a needed skill set or the completion of a specific task for the benefactor and can create a sense of accomplishment in the recipient. However, this process takes time, which means it isn’t an ideal solution if the need is immediate. Further, earned income may create an income tax liability for the recipient and reporting requirements for both recipient and benefactor.

Gifting is another means of transferring money to loved ones. Holidays and other occasions are common reasons for giving gifts, but of course gifts can be made at any time. Gifting solves a need for immediacy but creates no sense of accomplishment in the recipient; in fact, it may lead to a sense of reliance or dependency.

Intrafamily loans: Pros, cons, and important considerations

Loans are yet another option. Making loans to loved ones in financial need (or not) satisfies immediate needs while also creating a sense of responsibility and accountability. To qualify as a loan, repayment of principal is required as well as some amount of interest on the principal. This interest is the “cost” of the loan.

The applicable federal rate (AFR), which is set by the federal government and published monthly by the Internal Revenue Service, establishes the minimum interest rate required for private loans.  Private parties to a loan are free to agree on any interest rate higher or lower than the AFR; however, an interest rate that is less than the AFR may result in imputed taxable income to the lender or IRS treatment of the money transferred as a gift rather than a loan.

The IRS publishes three AFRs: short-term, mid-term, and long-term. The short-term rate applies to loans with maturities of three years or less. Mid-term AFR rates are loans with maturities of more than three and up to nine years. Long-term AFR rates apply to loans of more than nine years.

These interest rates are “fixed” for the entire period of the loan. However, the amount of interest paid can change if the loan documents include a “no prepayment penalty” clause, a “right of renewal” for the borrower, or can be renegotiated when agreed to by both borrower and lender. To minimize the financial burden on the borrower, many intrafamily loan agreements are structured as “interest only” loans with a balloon payment at the end of the loan period.

At the end of the loan term, the lender can call in the principal or renew the loan (taking into account the then-current AFR) or even gift all or some portion of the principal amount of the loan to the borrower (subject to the then-current transfer tax laws).

State laws control documentation of contracts, so it is important to obtain qualified legal advice regarding the loan documents required. Most loan documents typically require:

• Names, addresses, and contact information of the parties (lender, borrower, and cosigner if any)
• Principal amount of the loan
• Term of the loan
• Interest rate applicable and terms of repayment (amortized or interest-only)
• Where and when payments must be made (monthly or quarterly or annually)
• Prepayment terms
• If collateral is required, provisions for default (late payment or nonpayment)
• Date of execution and signatures of all parties to the loan contract.

Additional terms in the promissory note may be desired. Again, guidance from experienced local counsel can help avoid future conflict.

It is also important to consider the income tax consequences of intrafamily loans. , The interest on an unsecured loan paid by the borrower is generally not deductible. However, the interest payments received by the lender are typically taxable as ordinary income. Lenders and borrowers should consult with a tax professional to help determine the tax impact of such loans.

A friend in need is a friend indeed

While loans to family can provide a solution to a borrower’s immediate cash flow needs, there is a possibility that they may also create problems. Easy access to money has the potential to encourage, start, or prolong a habit of over-extending oneself financially. Late payments, default, and collection can create an uncomfortable family situation. Furthermore, intra-family loans are not reported to national credit reporting agencies and therefore do not build/add to a borrower’s credit history or rating.

Despite potential drawbacks, intrafamily loans can solve not only financial needs of the borrower but can also be used as an estate planning tool and a means of asset protection. In all cases, the pros and cons should be carefully considered prior to entering the loan contract.

The old proverb, “A friend in need is a friend indeed,” expresses the idea that a friend who comes to you when in need is truly a friend because he/she trusts you enough to help. The meaning of the expression is magnified when family is involved. Intrafamily loans allow financially secure family members to provide for needy family members while preserving some accountability on the part of the borrower and control on the part of the lender.

 

IMPORTANT INFORMATION

The information contained herein is for educational purposes only and should not be construed as financial, legal or tax advice. Circumstances may change over time so it may be appropriate to evaluate strategy with the assistance of a financial professional. Federal and state laws and regulations are complex and subject to change. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of the information provided. Janus Henderson does not have information related to and does not review or verify particular financial or tax situations, and is not liable for use of, or any position taken in reliance on, such information.