Market Interest Rate Loans: A Simple and Effective Potential Estate Planning Technique
The authors discuss the beneficial wealth results of having a younger family member, rather than a third party, lend money to an older family member in exchange for a promissory note bearing market rate of interest.
A cursory review of recent estate planning techniques reveals their complexity.(1) Estate planners tout the virtues of these techniques, but even they recognize that these techniques suffer from potential shortcomings.(2) In addition, the implementation of these techniques often weights heavily on the minds and pocketbooks of clients. Simply put, clients are bewildered by the myriad of steps these techniques require and are often frustrated by the legal and administrative costs they entail.
As an alternative to the complex techniques others champion, consider the following proposal. Have a younger family member rather than a third party lend money to an older family member who is in need of liquidity. In return, have the older family member issue a promissory note bearing market rate interest to the younger family member. This arrangement will often produce beneficial wealth results.
The rest of this article explains why this is the case. More specifically, this article discusses when the market interest rate loan technique will be most effective, and the concomitant income and transfer tax implications associated with its use.
In the past, a common estate planning technique was to use below-market interest rate loans to transfer wealth between family members. An older family member would lend money to a younger family member using a demand note that bore little or no interest. by utilizing this technique, all income and wealth generated on the borrowed funds in excess of any required interest could escape inclusion in the older family member's estate.(3)
Both the Supreme Court and Congress, however, put an end to taxpayers' use of below-market interest rate loans as an estate planning technique. In E.C. Dickman,(4) the Supreme Court declared that interest-free loans constituted gifts, measured generally by the amount of interest that could have been derived from investing the loan proceeds at market interest rates. Congress also responded with the institution of Code Sec. 7872. This section treats the borrower as paying interest to the lender and the lender, depending upon circumstances, making a gift of such interest to the borrower.(5)
The market interest rate loan technique inverts the below-market interest loan technique. The younger family member instead lends funds to the older family member. Consider the following fact pattern.
Example:A Father, age 70, has a net worth of $5 million and his son, age 45, has a net worth of $3 million. Father and son each have been experiencing a six-percent return on their liquid assets (e.g., cash and securities). Suppose the father would like to borrow money in order to buy a new vacation home or to invest in the stock market. He could approach his son for a loan. The son would loan the father the sum of $1 million and, in return, the father would issue the son a promissory note. The terms of the promissory note would provide for a balloon principal payment in 10 years and interest payable annually.
Suppose that the applicable long-term federal interest rate for the month the loan is entered into is eight percent(6) and that a commercial lender likely would command a 12-percent return. The parties would agree to set the interest rate governing the loan at 10 percent because the loan would be unsecured (the reason the interest rate is set in excess of the applicable federal rate) and the parties would want to shield themselves from a potential IRS argument that the father was making a gift to the son (the reason the interest rate is set lower than the commercial lending rate).
Over the next 10 years, the father would make interest payments that total $1 million (10% x $1 million x 10 years). If the father purchased a vacation home or invested the borrowed funds in the stock market and could command only a six percent rate of return on the borrowed funds or a total of $600,000 (6% x $1 million x 10 years), the father's estate would be depleted by $400,000. This money would inure to the son's benefit free of transfer tax (albeit, not free of income tax).
When the Technique Is Effective
The use of a market interest rate loan is not for all taxpayers. It presumes that the younger family member has: (a) financial liquidity due to his or her labor, investments, inheritances or "old and cold" gifts;(7) and (b) a willingness to loan money to an older family member. For many taxpayers, these necessary conditions will be a significant impediment from engaging in this technique.
Assuming these conditions are met, the market interest rate loan technique may make a lot of sense in a situation where an older family member needs liquidity. The older family member can often command an interest rate set below the commercial lending rate and borrow such funds without the usual concomitant paperwork and fees.
As an estate-planning tool, the effectiveness of the market interest rate loan technique also turns on the investment acumen of the parties involved and the interest rate stated on the promissory note. To illustrate this point, reconsider the fact pattern in Example 1 where son loans father $1 million in return for a promissory note bearing 10 percent interest. The economic benefits of making this loan turn on the rate of return the father actually earns and the rate of return the son could have earned had he not made the loan. The Comparison Chart illustrates this point.
Rate of Return and the Market Interest Rate Loan Technique
Rate of Return Son Could Have Earned Had Loan Not Been Made
Rate of Return Actually Earned by Father
I. Additional transfer tax transfer burden; shrinkage of overall family wealth
II. Additional transfer tax burden; increase of overall family wealth.
III. Reduction of transfer tax burden; shrinkage of overall family wealth.
IV. Reduction of transfer tax burden; increase of overall family wealth.
A review of the Comparison Chart reveals that the market interest rate loan technique is effective when the younger family member's investment ability is below that of the older family member's ability (quadrant II)(8) or where both the older and younger family members can command the same rate of return, but this rate of return is less than the rate stated on the promissory note (quadrant IV). In contrast, the market interest rate loan technique is not effective in those situations where both the younger and older family members are strong investors (quadrant I) or where the older family member is a weak investor relative to the younger family member (quadrant III). In these latter situations the use of the market interest rate loan technique does not make economic sense.
Aside from the situations where the older family member needs liquidity for personal or investment reasons, there is at least one other situation that lends itself well to use of the market interest rate loan technique. consider the plight of an older family member who has a portfolio of highly appreciated assets and little additional liquidity. If the older family member were to sell the appreciated assets, the older family member would have to recognize capital gains. In addition, the appreciated assets would not receive a step-up in tax basis to the fair market value of the assets upon the death of the older family member that would eliminate the capital gain on appreciation.(9) Use of the market interest rate loan technique, however, obviates these concerns; it affords the older family member liquidity without incurring an unnecessary capital gain.
Income and Transfer Tax Implications
The income tax consequences of market interest rate loans are well settled. The lender will have to report ordinary income for any interest payment received from the borrower on the loan.(10) The ability of the borrower to deduct the interest payments turns on how the borrower uses the borrowed funds. For example, if the borrower uses the borrowed funds for personal use (e.g., the purchase of a vacation home), the interest payable will be nondeductible.(11) Conversely, if the borrower invests the borrowed funds, the borrower may deduct the interest paid on the promissory note up to the amount of investment income the borrower earns.(12) (Whether the borrower can deduct the interest payments should be a factor used to determine the borrower's effective rate of return on the borrowed funds (see Comparison Chart.)
The transfer tax consequences associated with the use of the market interest rate loan technique are not as well settled. In situations where the market interest rate loan is set near or at commercial lending rate, the IRS likely would have a difficult time challenging the use of the market interest rate loan technique.(13) More specifically, if the older and younger family member maintain all the indicia of a bona fide loan (e.g., have a valid and enforceable promissory note and abide by its terms), prior court cases indicate that the taxpayer should prevail.(14)
The IRS's best line of attack against the market loan technique would be to declare that this arrangement constitutes a mere device or sham intended to effectuate a tax-free transfer of wealth.(15) For example, the IRS could bolster its position if the younger family member commanded an interest rate on the promissory note that is higher than the comparable commercial lending rate(16) because the older family member could have sought a third party lender as a source of funds at a lower interest rate. The fact that the older family member did not use the services of the third party lender belies his intent to make a gift. The amount of the gift is unclear. It could be (a) the interest differential between the rate charged and the applicable federal rate; or (b) all the interest charged.
If taxpayers want to know whether the IRS will attempt to treat interest payments as gifts, the older family member can consider filing a gift tax return. On the return the older family member would reflect a zero taxable gift with respect to the loan and attach a rider explaining the details of the loan. By making adequate disclosure, the IRS may challenge the loan only within the applicable statute of limitations.(17)
Finally, unlike other estate planning techniques (e.g., grantor retained annuity trust),(18) the death of the older family member before the loan terminates should not thwart possible estate planning results. While the estate will include the proceeds of the loan, it should be entitled to a corresponding debt deduction equal to the face amount of the note and accrual interest (if any) up to the date of death.
In sum, the market interest rate loan technique enjoys the virtues of being readily comprehensible and easily implemented, features lacking in many of today's sophisticated estate-planning techniques. In addition, when handled properly, use of the market interest rate loan technique should be able to withstand attack by the IRS.
Jay Soled is a Professor at Rutgers University, in Newark, New Jersey.
Simon Levin is a Partner at the law firm of Sills Cummis Radin Tischman Epstein & Gross, P.A., in Newark, New Jersey.
The authors thank Bruce E. Mantell of the Mantell Law Firm for his comments and insight in preparing this article.
1. E.g., Elliot Manning and Jerome M. Hesch, Deferred Payment Sales to Grantor Trusts, GRATS and Net Gifts: Income and Transfer Tax Elements, 24 J. Est., Gifts and Tr. 3 (Jan./Feb. 1999).
2. E.g., Robert J. Adler, Wrong Wording Kills Exclusion for Limited Partnership Interest Gifts, 61 Tax'n for Acc. 80 (1998).
3. E.g., L. Crown, CA-7, 78-2 USTC 13,260, 585 F2d 234 (interest-free loans to family members payable on demand were not subject to federal gift tax).
4. SCt, 84-1 USTC 13,560, 465 US 330, 104 SCt 1086.
5. Code Sec. 7872(c)(1)(A).
6. Code Sec. 1274(d).
7. The family has a much greater risk that the IRS will challenge the market interest rate loan technique if the older family member makes a gift to the younger family and the younger family member immediately loans the gift back to the older family member. See Rev. Rul. 87-69, 1987-2 CB 46 (no true debt existed where the taxpayer gave his child $40,000 on the condition that the child lend the money back to the taxpayer); G.J. Parkhill, DC-Tex, 75-1 USTC 9118, 385 F.Supp 204 (interest deduction denied because the purported gifts of farm crops by the taxpayer to his children coupled with a loan of the crop proceeds to the taxpayer from the children lacked validity). Compare P. O'B Montgomery v. Thomas, CA-5 45-1 USTC 9116, 146 F2d 76 (where a gift was complete, the loan back to the donor was valid and the interest deductible).
8. However, query the economic judgment of an older family member engaging in riskier investments than those of a younger family member. Also, in many situations, the less experienced or astute investor will be directed in his investment decisions by the stronger investor so that the investment ability of both family members will be the same.
9. Code Sec. 1014(a).
10. Code Sec. 61(a)(4).
11. Code Sec. 163(h).
12. Code Sec. 163(b).
13. E.g., C.L. Hunt, 57 TCM 919, Dec. 45,833(M), TC Memo. 1989-335 (loan made to children did not constitute a gift where interest rate charged on the loan equaled prime rate of interest charged at a local bank).
14. The Tax Court considered the following factors to determine whether a loan was bona fide: (1) if there was a promissory note or other evidence of indebtedness; (2) if interest was charged; (3) if there was any security or collateral; (4) if there was a fixed maturity date; (5) if a demand for repayment was made; (6) if any actual repayment was made; (7) if the transferee had the ability to repay; (8) if any records maintained by the transferor and/or the transferee reflected the transaction as a loan; and (9) if the manner in which the transaction was reported for federal tax purposes was consistent with a loan. E.G. Miller, 71 TCM 1674, Dec. 51,105(M), TC Memo. 1996-3. Aff'd, CA-9 (unpublished opinion), 97-1 USTC 60,277.
15. E.g., M.F. Perrett, 74 TC 111, Dec. 36,914. Aff'd, CA-9 (unpublished opinion), 679 F2d 900 (funds loaned by taxpayers to trusts established for their children at a low interest rate followed by the trusts' loaning the funds back to the taxpayers at a higher interest rate several days later merely permitted taxpayers to make contributions (by means of the interest rate differential) to the trusts that would be deducted as interest); Rev. rul. 82-94, 1982-1 CB 31 (parents' "loan" of $50,000 to a child on the condition that child loan the money back to parents (which was done at a 17-percent rate) had no economic reality and, thus, did not create a valid debtor-creditor relationship between the parties).
17. Code Sec. 6501(f).
18. Code Sec. 2036(a).