
In today’s economic landscape, strategic financial planning is more important than ever. Parents looking to gift money to their children can find themselves burdened by hefty transfer taxes.
However, there’s a smart and efficient way to circumvent this issue—loans. By loaning money to your children or to grantor trusts for their benefit, you can achieve significant tax savings. Here’s how.
Taxes on Financial Gifts to Children
When parents gift money to their children, those funds are usually subject to gift taxes. In 2024, the annual exclusion amount for gifts is $18,000 per recipient, meaning you can gift up to $18,000 to any individual each year without incurring gift tax.
Gifts above this amount may be subject to federal gift tax rates as high as 40%, which could result in a substantial financial burden.
Tax Benefits of Loaning Money to Your Children
Instead of gifting money, parents can loan it. When structured correctly, loans can offer a tax-efficient way to transfer wealth. By charging the required interest rate, parents can avoid the gift tax while still transferring significant value to their children.
Required Interest – The Applicable Federal Rate
The IRS mandates a minimum interest rate that must be charged on loans between family members. To be classified as a gift, loans must charge at least the Applicable Federal Rate (AFR), which varies based on the loan’s term.
- Short-term AFR (under 3 years)
- Mid-term AFR (3-9 years)
- Long-term AFR (loans over 9 years)
Example 1: Loan to Children
In September 2020, the long-term AFR was 1%. If the parents loan $10M to their children on an interest-only note with principal due in 20 years, the children would be required to pay $100,000/year in interest.
Assume the children invested the $10M and earned a 4% return ($400,000 gain). After deducting $100,000 in annual interest payments, the children are left $300,000.
Tax Outcome
The parents would pay income tax on the $100,000 interest received which, if structured properly, can be deductible.
The children would pay income tax on the net $300,000 they earned. Assuming a combined federal and state income tax rate of 40%, their net would be $180,000.
Thus, the parents were able to avoid gift taxes on the transfer of $180,000 to their children. Assuming a 40% gift tax rate, this equates to $72,000 in tax savings. Over 20 years (assuming the same facts), this strategy saves the parents $1.44M in transfer taxes.
Example 2 – Loan to Grantor Trusts for Children
(Same assumptions as Example 1, but with $10M to a grantor trust)
In this scenario, the trust earns $400,000 and pays the parents $100,000 in interest over the course of year, which keeps the net at $300,000.
Tax Outcome
The parents are subject to income tax on the $400,000 earned by the trust, but not the interest received. The trust gets no deduction for that payment.
The Loan Must Be Respected as a Loan
For a loan to result in tax savings, it must be treated as a legitimate loan. The IRS reviews several factors to determine if the loan is genuine:
- The presence of a promissory note or evidence of indebtedness
- Interest charged
- Security for the loan
- Fixed maturity date
- Demand for repayment
- Actual repayment made
- Borrower’s ability to repay
- Transaction records reflecting it as a loan
- Reporting the transaction for federal income tax purposes
Proper documentation and adherence to loan terms are crucial. If the loan is to a grantor trust, there isn’t any tax reporting required. For loans directly to children, tax reporting as payments of interest on a promissory note is essential.
Statute of Limitations Concerns
If a loan becomes due and payment isn’t made or demanded within a statutory period (typically 3 to 5 years), it may become uncollectible, and the IRS may treat the unpaid loan as a gift. This highlights the importance of making payments as required by the note.
Flexibility Provided to Parents by Loans
Loans offer flexibility if parents’ financial situations change. If needed, parents can request early repayment of the loan. For loans to children, parents can hope for early repayment if necessary. For loans to grantor trusts, parents can replace the trustee to ensure repayment. Promissory notes should allow for penalty-free prepayment.
When is the Best Time to Loan Money to Your Children?
The best time to loan money is when interest rates are low. Low AFRs make it easier for children or trusts to earn returns higher than the interest rate, maximizing the tax-free transfer.
If Interest Rates Drop, Can the Loan Be Re-Financed at a Lower Interest Rate?
Yes, loans can be refinanced at a lower interest rate if the AFR drops. This ensures continued tax efficiency. However, if the note is renegotiated there must be consideration – meaning, the borrower should either pay down a portion of the principal or agree to shorten the note term.
Wrapping it Up
Loans can be a powerful tool for parents looking to transfer wealth to their children in a tax-efficient manner. By following proper guidelines and ensuring the loan is respected as such, significant tax savings can be achieved.
If you’re considering this strategy, consult with a financial advisor to tailor the approach to your situation.