Using a Trust to Help Financially Straightened Family Members

by | Jan 21, 2022 | Taxes

Even though there are signs that interest rates are likely to rise in the near future, they remain low for now. This means that the benefits of making intrafamily loans remain compelling. Not only can you assist loved ones with favorable terms, but you may be able to reduce gift and estate taxes.

The good news is that you may not need liquid assets to make a loan. If you’ve established a trust, your beneficiaries may be able to borrow from it. However, there are rules (for example, your trust must allow loans) and you should evaluate the decision with the help of a professional advisor. Here’s some basic information about trust loans.

Gifts Are Better, But Loans Can Work

An intrafamily loan can be a great way to help out family members financially while also transferring significant amounts of wealth free of gift and estate taxes. Why not simply make an outright gift? Actually, a gift typically is the better option, so long as your unused estate and gift tax exemption is enough to cover it and you don’t need the funds or the interest income. But if transfer taxes are an issue or you’re not prepared to part with the money just yet, a loan can be an attractive alternative.

Generally, to pass muster with the IRS, the interest rate on an intrafamily loan must be at least the applicable federal rate (AFR) for the month in which the loan is made. Otherwise, the IRS may view the loan as a disguised distribution — which can result in a variety of unpleasant tax complications. The loan should also be documented by a promissory note and otherwise treated as an arm’s length transaction. If the borrower places the funds in investments that enjoy returns that are higher than the interest rate on the loan, then the excess appreciation is, in effect, a tax-free gift.

When Distributions Aren’t Possible

If an intrafamily loan isn’t an option, it may be possible for a trust beneficiary to obtain a loan from the trust. You might wonder why a beneficiary would borrow from the trust rather than take a distribution. There are several situations in which a loan may be necessary or desirable, including, for example, if the trust’s terms place conditions on distributions that aren’t currently satisfied. Other examples are when:

  • A borrower seeks an amount that exceeds limits on distributions imposed by the trust,
  • The trust has multiple beneficiaries and the borrower seeks an amount that would be unfair to other beneficiaries if taken as a distribution, and
  • A loan is preferable for tax-planning purposes.

Many trust instruments explicitly authorize loans. But even if the trust is silent, the law in many states permits loans unless the trust expressly prohibits them. But be sure to check before getting your heart set on a trust loan.

Trustees’ Fiduciary Duty

There’s a critical difference between intrafamily loans and trust loans. A trustee has a fiduciary duty to manage the trust in a prudent and impartial manner. If you lend money to family members from your personal assets, you’re generally permitted to structure the transaction as you see fit. However, a trustee considering a loan request must act in the best interests of the trust and all of its beneficiaries. So, for example, trustees who approve loans to beneficiaries who have defaulted on other financial obligations may be breaching their fiduciary duty.

To fulfill this duty, a trustee needs to treat the loan as an investment of trust assets. That means the interest rate should be reasonable in comparison to other potential investments (the AFR probably isn’t sufficient here) and the trustee should consider steps to ensure collection, such as assessing the borrower’s ability to repay and securing the loan with adequate collateral.

Of course, if a trust loan’s terms are comparable to those available from a bank, the trustee should question why the beneficiary isn’t simply obtaining a bank loan. If the answer is that the beneficiary isn’t creditworthy, the trustee should act in the trust’s best interests by rejecting the loan request, increasing the interest rate or demanding additional collateral.

Avoid Serious Errors

Trusts aren’t do-it-yourself vehicles. Whether you want to establish a trust or allow a beneficiary to borrow from an existing one, get professional advice. In addition to help you maximize tax benefits and leave a legacy to your loved ones, your advisor can provide the critical “gut check” that helps clients avoid making serious financial errors.