COVID-19 Pandemic Borrowing from Family at Ultra-low Rates Creates Estate Planning and Tax Challenges

Photo 44168004 © Marco Scisetti | Dreamstime.com

"Desperate small business owners seeking cash to keep their businesses alive during the coronavirus pandemic are turning to their families for loans," according to an article recently published in Forbes:

“People are risking their own money for their brother, sister, kids, grandkids,” says Rebecca MacGregor, an estate planning lawyer with Bowditch & Dewey in Boston, Massachusetts. She’s recently set up intra-family loans in the case of clients trying to hold onto a gas station, a third-generation Italian restaurant and a fifth-generation insurance agency. “No one is singing the praises of the family and friends who are saving these small businesses,” she says. “They’re unsung heroes.”

Familial loans with ultra-low interest rates are a lifeline.

It is hard to know how common familial generosity is, but an overwhelming 71% of retirees said they would offer financial support to their family needed due to Covid-19 even if it could jeopardize their own financial future, a recent retirement study by Edward Jones and AgeWave found.

The Internal Revenue Service announces special interest rates (applicable federal rates or AFRs) monthly, and for August, per IRS Revenue Ruling 2020-15, here’s how low they are:

• Short-term — Three years or less: 0.17%
• Mid-term — More than three years and less than nine years: 0.41%
• Long-term — More than nine years: 1.12%

Obviously, no borrow is going to find these rates at a bank.  They are incredibly low, but it is, in part, a reflection of the fact that the risk is incredibly high. That is, unfortunately, an important consideration in extending loans to family. 

According to the Forbes article, while many business owners received CARES Act paycheck protection program loans, they are now turning to family members. Families are lending money to keep businesses afloat in the hopes that once Covid-19 passes, customers will return, and the loans can be repaid.

If you are considering becoming a familial lender, it is vitally important to consider how much you are comfortable and able to lend.  You should, in fact, assume the worst, that your loan will become a gift, and hope for the best. You should consider carefully how much you have saved for your lifetime, and how comfortably you are living within your income.

An intra-family loan is a private loan, instead of a loan through a known bank lender, but if the amount of the loan exceeds $10,000, you should have the same type of documents as for a bank loan. These should be documented as real loans intended for repayment, and if there is available security,. such as inventory or real estate, the lender should be protected and secured.  Neither borrower nor lender will be happy if, in the worst case, assets are liquidated to pay creditors other than family because commercial lenders were protected, while the family lender was not. 

 You can make the loan payment an "interest only," or make it a traditional payment of interest and principle. You can structure the loan so the lender gifts part of the principle over time. So long as the gift stays under $15,000 per individual/$30,000 per married couple, there is no requirement to file a gift tax return. Regardless, if the gift exceeds that amount, there is typically no gift tax assessed; the lifetime gift tax exclusion is $11.58 million per person, so there is no gift tax due. If the gift is more than $15,000/$30,000, you are technically required to file a gift tax return and report use of a portion of your lifetime gift tax exclusion. 

Be careful of no-interest or too-low interest loans; they risk imputed interest income, and resulting penalties and interest from non-reporting. Imputed interest is the interest that a lender is presumed to have received and must report as income on their taxes regardless of whether they received it. It applies to family loans and other personal and business loans extended at no interest or an interest rate the IRS considers to be too low. For more information, go here and here. 

Finally, if you are considering any familial financial arrangement, it is important to discuss your desires with your estate planner.  Many trusts and some Wills have provisions that claw-back advancements, such as unrepaid loans or gifts made for a period prior to death, from shares of the estate directed to heirs.  In other words, these arrangements may merit or require changes to your estate plan.