Family Loans

Family Loans

After reviewing the monthly DataNet Newsletter for March 2016 that updates the AFR interest rates in connection with a corporate transaction I have been involved in, I noticed the short-, medium- and long-term federal AFR rates all declined from the previous month. For the month of March, 2016, the rates are .65% for short-term loans not exceeding three years, 1.48% for mid-term loans not exceeding nine years and 2.33% for long-term loans in excess of nine years. So while interest rates are still low and not knowing for sure if they are heading up or down (although I tend to believe there are better odds for gradual increases), I thought it would not hurt to mention that family loans, if done correctly, may still offer a fairly simple method of achieving some family estate and financial planning.

Family loans can certainly be cheaper, quicker and a bit easier to obtain than going to the bank. But in order to avoid gift treatment by the IRS, they should only be made by following the various factors that the IRS examines in determining whether a transaction constitutes a bona fide loan transaction. Therefore, proper drafting, adhering to the terms of the loan, no pre-conceived intent of gift, debtor’s financial status and lender recognition of interest income are just a few of the factors that the IRS will examine in determining whether a specific transaction constitute a bona fide outright gift.

Loans should be evidenced by promissory notes. The more the transaction takes on the feel of an “arm’s length” transaction, the more likely it is that the IRS will accept it as a loan. For example, if there are communications between mom and son indicating mom is really not expecting payment to be made, that will create a real problem with the IRS as to the bona fide nature of the “loan.”

A question that clients periodically bring up is whether a note may be cancelled or forgiven upon their death. This is called a Self-Cancelling Installment Note (“SCIN” for short). A SCIN can be an effective tool for passing along family wealth, but again only if it is properly drafted and after all of the IRS issues and concerns are properly considered and addressed. One thing is certain, however. A note of this type has to charge some additional consideration or premium amount over and above normal rates charged as consideration for the inclusion of the self-cancelling feature. A note using an AFR rate as its interest rate is clearly not sufficient.

Certain aspects of this information will be addressed in future blogs.

Michael W. Margrave

Disclaimer: This blog is for information purposes only. Legal advice is provided only through a formal, written attorney/client agreement.