Key highlights:
- When paired with grantor trusts, intrafamily loans using low IRS Applicable Federal Rates (AFRs) can help families avoid tens of millions of dollars (or more) in gift or estate taxes
- While powerful, this strategy carries investment risk and requires proper structuring and maintenance
When people think of estate-tax planning, the first thing that comes to mind is gifting assets to future generations (or trusts for those future generations). Indeed, gifting assets — particularly to irrevocable trusts — can be highly estate-tax efficient because it moves those assets (along with any future appreciation) off the donor’s balance sheet. But there are other techniques that taxpayers can use to move assets out of their personal names. One simple yet powerful technique is loaning money to family members and/or irrevocable trusts. This article explores how individuals can use these intrafamily loans to pass on more assets to future generations and minimize their estate-tax exposure.
The basic idea
An intrafamily loan is a loan from one family member to another family member or a trust for that family member’s benefit. The IRS sets minimum interest rates for intrafamily loans known as the ”Applicable Federal Rates” or “AFRs.” These interest rates, which are derived from U.S. Treasury yields, are usually in the 2-4% range (far lower than what an actual bank would charge for an unsecured loan). As an estate-tax strategy, intrafamily loans work as long as the borrower invests the borrowed money in an investment that outperforms the loan’s (low) interest rate. The spread between the interest rate and the investment return will belong to the trust, meaning it will be outside of the taxpayer’s estate for estate-tax purposes. Thanks to the magic of compound growth, even a 5% spread can make a big difference given a long enough time horizon.
These loans can pass large amounts of wealth to younger generations. Yet, properly structured loans that are made at the AFR (or a higher rate) are not considered gifts for gift-tax purposes since the lender is receiving interest in return for making the loan. As a result, loans don’t use the lender’s lifetime gift-tax exemption (the amount that an individual can gift during his or her lifetime without owing any gift tax).
Example of an intrafamily loan
Let’s say Bob loans $5 million to a grantor trust he set up for his kids and grandkids, and the loan has a 25-year term and a 4.2% interest rate. If the trust invests the $5 million in an investment that generates 10% annual returns (close to the S&P’s historical return rate) and makes interest payments annually, then by Year 25 that investment should be worth about $20 million. Even after repaying the principal, there will be $15 million remaining in the trust as a direct result of that $5 million loan. That’s $15 million that was moved into an irrevocable trust that’s outside Bob’s estate, without him using up any gift-tax exemption! The resulting estate-tax savings will be at least $6 million ($15 million x 0.40).
But that’s actually understating the true savings. First of all, a dozen states and the District of Columbia have their own estate taxes in addition to the federal estate tax. If Bob lives in one of those states, the post-tax savings will be closer to $7.5 million. Moreover, the loan helps the trust indirectly move another ~$15 million out of Bob’s estate due to a phenomenon known as “estate-tax burn” — whereby the grantor pays a trust’s income-tax liability each year without those tax payments qualifying as taxable gifts. All told, the $5 million loan will have moved roughly $30 million out of Bob’s estate in just 25 years without Bob making any “gifts” beyond whatever he’d already gifted to the grantor trust.
Meanwhile, Bob will have gotten $210,000 a year in interest payments back from the trust — cash flow that he might appreciate. And, because a grantor trust is disregarded for income-tax purposes, the interest payments won’t create any income-tax liability for Bob (you can learn more about grantor trusts here).
What are the loan terms for intrafamily loans?
As discussed above, intrafamily loans typically use the relevant AFR interest rates in the month that the loan is made. There are actually three AFRs: a short-term rate (for loans with terms of under three years), a mid-term rate (for loans with terms of between three and nine years), and a long-term rate (for loans with terms of greater than nine years). Most intrafamily loans require interest payments to be made annually, with principal due in a single balloon payment at the end of the term and no prepayment penalties. The balloon payment means that the borrower can invest all the principal for the entire term of the loan and allow the trust to build more wealth. Most intrafamily loans are unsecured.
What are the income-tax consequences of intrafamily loans?
If you loan money to an individual family member or a trust that is treated as a separate taxpayer for income-tax purposes (a “non-grantor trust”), the interest payments will generate income-tax liability. But if you loan money to a “grantor trust” — that is, a trust that is ignored for income-tax purposes — the interest payments will not generate any taxable income. Moreover, it’s possible to lend non-cash assets, like publicly traded stock or bonds, to a grantor trust without selling the assets or generating any capital gains recognition. This is why most people prefer to lend to grantor trusts for the benefit of their family members, rather than to the family members themselves. Trusts offer many other benefits as well.
How do you administer an intrafamily loan?
Administering intrafamily loans is pretty straightforward. The key is to make sure interest payments (and principal payments, if applicable) are paid on time. The relatively low overhead involved is a major advantage of the loan technique. (As an aside, Valur is a one-stop shop for trust and tax administration. We make setting up a trust for the benefit of your family members, generating a promissory note, and tracking loan payments easy and affordable. You can chat with us here if you want to learn more.)
What is the investment risk of an intrafamily loan?
This strategy is not without risk. If the borrower’s investment tanks, the borrower will lose money on the investment and still need to pay back the loan. The worst-case scenario is that someone lends highly volatile stocks to a trust only for the value of the stock to evaporate, leaving the trust deep in the hole. Grantor Retained Annuity Trusts are often better suited for transferring highly volatile assets, like individual stocks. Less volatile investments, like index funds, are well suited for investing borrowed assets.
How much can you loan to a trust?
You can loan as much or as little to a trust as you’d like. Of course, the more you loan to a trust, the higher the potential tax savings for your heirs but the higher the potential risk. The IRS itself doesn’t set rules for how much you can lend, but you want the loan to look more or less like the sort of loan a bank might make (albeit, with a better interest rate). A rule of thumb is that when loaning money to a trust, the loan principal should not exceed 9x the trust’s pre-loan assets. So if a trust has $14 million of assets, it can borrow $126 million! And if the trust’s assets grow at a rate faster than the loan’s interest rate this year, it can borrow even more money next year.
Borrowing from trusts
This article has focused on loans from a taxpayer to a grantor trust (or family member). But it’s also possible for an individual to borrow from a grantor trust that he or she set up. As with the other grantor trust loan scenarios discussed in this article, the interest payments would be non-taxable. The ability to borrow from a trust on short notice — which might be necessary in the event of a cash crunch — is one of the many perks of setting up a grantor trust. Though, of course, borrowing from a trust won’t shift assets out of your estate, and it might do the opposite.
Bottom line
Intrafamily loans, particularly when paired with grantor trusts, are a great way to minimize future estate-tax liability. Contact Valur if you’re interested in setting up a grantor trust and taking advantage of this powerful estate-tax strategy. Valur can also model the tax savings that a loan will generate.
About Valur
We’ve built a platform to give everyone access to the tax and wealth-building tools typically reserved for wealthy individuals with a team of accountants and lawyers. We make it simple and seamless for our customers to take advantage of these hard-to-access tax-advantaged structures. With Valur, you can build your wealth more efficiently at less than half the cost of competitors.
From picking the best strategy to taking care of all the setup and ongoing overhead, we make things simple. The results are real: We have helped create more than $3 billion in additional wealth for our customers. If you would like to learn more, please feel free to explore our Learning Center. You can also see your potential tax savings with our online calculators or schedule a time to chat with us!
