If you’re like most people, an important goal of estate planning is to provide financial assistance to your children or other loved ones, ideally at the lowest possible tax cost. There are many strategies for achieving this goal, including outright gifts (either during life or through bequests in your will) and gifts in trust.
Another option is to make loans to family members. Intrafamily loans offer several benefits, but to enjoy those benefits it’s critical to treat these transactions as legitimate loans. Otherwise, the IRS may determine that they’re disguised gifts, which can trigger negative tax consequences (assuming you’re subject to gift and estate taxes).
Benefits of intrafamily loans
One positive aspect of lending money to your loved ones rather than making outright gifts is that it allows you to help them financially without parting with the funds permanently. This can be advantageous if you believe that you’ll need the funds in retirement. Making loans can also be a great way to teach family members about financial responsibility.
From a tax perspective, intrafamily loans allow you to transfer wealth tax-free. Here’s how it works: When you make a loan to a family member, charge interest at the applicable federal rate (AFR). (Charging no interest or interest below the AFR can lead to unwelcome tax surprises.) To the extent that the borrower earns returns on the funds in excess of the interest payments on the loan (by investing them in a business opportunity, for example), the borrower pockets those earnings free of gift and estate tax.
Note that intrafamily loans don’t enable you to avoid gift and estate tax on the loan principal itself. The outstanding balance is included in the lender’s taxable estate, even if the lender dies before the loan is paid off. In that case, either the borrower will be obligated to repay the loan to the estate or, if the loan terms call for it to be forgiven upon the death of the lender, that forgiveness will be treated as a taxable transfer.
Loan vs. gift
The IRS presumes that intrafamily transactions are gifts. So, to ensure that a loan is treated as such, you must take steps to demonstrate that you and the borrower have a bona fide creditor-debtor relationship. To decide whether an advance is a loan or a gift, the IRS and the courts consider the “Miller” factors, under which an advance is more likely to be treated as a loan if:
- There was a promissory note or other evidence of indebtedness,
- Interest was charged,
- There was security or collateral,
- There was a fixed maturity date,
- A demand for repayment was made,
- Actual repayment was made,
- The transferee had the ability to repay,
- The parties maintained records treating the transaction as a loan, and
- The parties treated the transaction as a loan for federal tax purposes.
These factors aren’t exclusive. Also, the courts generally view an actual expectation of repayment and an intent to enforce the debt as critical to a finding that an advance is a loan.
Loan today, gift tomorrow
As illustrated by a recent federal court case, a history of intrafamily loans is no guarantee that subsequent advances won’t be treated as gifts. Estate of Bolles involved a mother who, from 1985 through 2007, made a series of payments to her son totaling more than $1 million. The mother characterized the payments as loans to assist her son in running the family business, though there was no promissory note or other evidence of indebtedness.
The son repaid some of the advances but made no payments after 1988, when the business ran into financial difficulty (and ultimately failed). In her revocable trust dated October 27, 1989, the mother specifically excluded the son from any distribution of her estate. In 1995, she amended the trust to reduce any distribution by the amount of the unpaid “loans,” rather than exclude him altogether. Around the same time, the son signed an acknowledgement that “he has neither the assets, nor the earning capacity, to repay” the previous loans.
The U.S. Tax Court, in a decision affirmed by the 9th U.S. Circuit Court of Appeals, found that the payments from 1985 through 1989 were loans, because the mother expected the son to make a success of the business. But by the time she executed her trust, she realized that the advances were unlikely to be repaid. The payments lost their characterization as loans at that time, the court explained, and became advances on the son’s inheritance.
Dot the i’s and cross the t’s
If you make loans to family members, it’s important to observe the formalities associated with bona fide loans to ensure the desired tax treatment. Among other things, this means having the borrower sign a promissory note, charging sufficient interest and making an effort to collect.
Sidebar: Is now the time to forgive intrafamily loans?
Keep in mind that the gift and estate tax exemption amount for 2024 is $13.61 million for individuals (a combined $27.22 million for married couples) and those amounts will be cut roughly in half in 2026, unless Congress intervenes. As long as your wealth is well within the exemption amount, treatment of an advance as a gift rather than a loan won’t trigger gift or estate tax.
If you have outstanding intrafamily loans and you’re concerned that the IRS may treat them as gifts, consider forgiving them before the end of 2025 to ensure that your gift locks in the higher exemption amount. Unless you really need the interest income, forgiving loans will allow you to transfer the funds tax free without the risk that future exemption amounts won’t be sufficient to shield them from tax.
