In the current economic environment and with interest rates hovering at or below 1%, many clients are considering making low interest loans to family members as a way to transfer wealth.
Intrafamily loans can be attractive for many reasons, including that the minimum interest rates imposed by the Internal Revenue Service on intrafamily loans are lower than commercially available interest rates and that a family member lender is unlikely to require as much (if any) financial disclosure or collateral as a commercial lender would. Intrafamily loans are especially attractive for clients who have already used their entire lifetime gift tax exemptions. If the loaned funds are invested and appreciate at a rate greater than the loan interest rate, the excess appreciation remains with the borrower (an individual or an irrevocable trust) at no gift tax cost.
While the concepts surrounding intrafamily loans by individual clients are well known to practitioners, a related area—the rules governing loans by irrevocable truststo their beneficiaries—may be less familiar. If interest rates remain low, requests for loans from trusts are likely to increase, and trustees must weigh the pros and cons carefully.
Unlike a family matriarch or patriarch making a loan out of personal assets, a trustee owes fiduciary duties to all the trust beneficiaries, including the duties to manage the trust assets with care, prudence and impartiality. When a trust beneficiary requests a loan, how should a trustee evaluate the request? Put differently, is it ever a good idea to make such a loan?
Three Case Studies
Let’s begin by considering three case studies in which a trustee might find a loan to be justified and the concerns associated with each.
Case Study 1: Imagine a trust that’s exempt from generation-skipping transfer (GST) tax and held as a single commingled fund for several generations of beneficiaries. Imagine also that a beneficiary who isn’t a skip person requests a distribution. The trustee doesn’t want to waste GST tax-exempt property on a non-skip person, so opts to make a loan from the trust instead.
In this case, the trustee’s primary concern is to avoid potential re-characterization by the IRS of the loan as a disguised distribution of GST tax-exempt assets, leading to an inefficient transfer-tax result. Proper loan documentation and a reasonable interest rate will be important. The trustee must also consider whether the non-skip beneficiary will be able to repay the loan.
If repayment is unlikely, the trustee must ask herself what a loan can accomplish (versus a distribution) if a distribution of GST tax-exempt assets may be needed in any event to assist with repayment. On the other hand, by making a loan, the trustee at least preserves the possibility of repayment by the borrower. And, in the interim, the loan will earn a return (interest) for the other beneficiaries, which wouldn’t be the case if the trustee made a distribution on Day 1.
Case Study 2: Imagine a trust with multiple beneficiaries, current and remainder, whose interests must be balanced by the trustee. Imagine also that a current beneficiary requests a disproportionate distribution, and the trustee decides to make a loan instead.
In this case, the trustee is driven less by tax considerations (as in Case Study 1) and more by equity concerns among the beneficiaries. She must ask herself how the other beneficiaries will react to a loan being made to one beneficiary. Making a loan reduces the trust’s other investment assets. Will the contemplated loan provide an adequate return to compensate the other beneficiaries for acting as the bank and for the opportunity cost of lost investments in other assets?
Further, what if the borrower-beneficiary defaults? Charging adequate interest and taking collateral will be important.
Case Study 3: Imagine a trust instrument that allows for only limited distributions—for example, an income-only trust or a trust that imposes other explicit limits on aggregate principal distributions. A beneficiary requests a distribution that would exceed those limits. The trustee decides to accommodate the beneficiary by making a loan.
In this case, the trustee’s primary concern is the trust instrument itself. If the donor imposed explicit limits on distributions, how is it consistent with the donor’s intent to exceed those limits with a loan? This perceived conflict can be easily resolved if the trust instrument expressly allows loans; in that case, the donor clearly contemplated that loans could be made instead of, or in addition to, distributions. Even if the instrument is silent, the apparent conflict can still be resolved. Because the donor took no position on trust loans, the trustee may look to underlying state law. If that law authorizes loans, then they’re possible.
As compared to Case Study 1 and Case Study 2, because excess distributions aren’t possible to assist the beneficiary with repayment in Case Study 3, there’s no solution of last resort (trust distributions) if the beneficiary can’t repay.
In light of this heightened emphasis on repayment, a loan from an income-only (or similarly limited) trust may be appropriate only in special circumstances. For example, a trustee might make a short-term loan tied to a temporary life circumstance, such as a bridge loan between selling one house and buying another, secured by a mortgage on the existing residence.
Making the Loan
Assuming a trustee in one of these situations is inclined to make the loan, she must make several decisions, all of which impact whether the loan will be judged as reasonable and prudent.
Check the trust instrument; are loans allowed? First, the trustee must determine if the trust instrument allows loans to beneficiaries. For newer instruments, the answer will almost certainly be yes. As noted, even if the instrument is silent, general legal principles likely authorize loans. For example, in Massachusetts, unless the instrument expressly states otherwise, Section 816(18) of its trust code authorizes a trustee to “make loans out of trust property, including loans to a beneficiary on terms and conditions the trustee considers to be fair and reasonable under the circumstances, and the trustee has a lien on future distributions for repayment of those loans.”1
Is it a good idea? Even if the trust instrument or underlying state law allows loans to beneficiaries, the trustee must still determine whether it’s a reasonable use of trust assets. A loan isn’t a distribution; in fact, it’s usually very important, for tax or equity reasons, that it not be treated as such. Rather, it’s an investment of trust assets, like a bond. By making the loan, the trustee is forgoing other investment opportunities and their associated returns. The loan should be judged, therefore, like any other investment.
If the loan isn’t properly secured or bears below-market interest, the other beneficiaries may have grounds to allege that the trustee breached her fiduciary duties.
If a trustee has any doubts at all, the best way to proceed is to disclose the possible loan to all the trust beneficiaries and ask for a written statement of non-objection. A non-objection is safer than affirmative consent, as affirmative consent arguably raises the specter of a gift among the beneficiaries if it can be argued that the trustee and the beneficiaries acted together in making the loan.
Every family is different, and what might be viewed as reasonable among one group of family beneficiaries may be unreasonable in the eyes of another. Knowing where the family stands on the subject of loans in advance, by seeking input from all the beneficiaries, is wise.
How should the loan be documented and secured? An obvious point is that any loan should be documented. The borrower should sign a contemporaneous promissory note, which should be kept with the trust records.
The trustee must also determine whether to take a security interest to protect the trust’s investment. Viewed from the perspective of the non-borrower beneficiaries, a security interest is important to protect the trust in the event of a default, providing an asset of value in place of the borrower-beneficiary’s repayment. If the trustee decides to take a security interest, it should be documented by a mortgage deed, Uniform Commercial Code filing or other written security agreement.
On the subject of collateral, it’s important to note that not all security interests are created equal. Some assets are easier to foreclose on than others. While liquid assets are theoretically better security (easier to monetize), taking an effective security interest in stocks and bonds requires the trustee to regularly monitor the pledged account. Many trustees aren’t set up for this sort of ongoing compliance.
Separate from collateral, the trustee should also consider if there will be a moment in time when the borrower will be able to repay, for example, on inheritance from an elderly family member. If so, the loan could be structured so as to be due on the earlier of a term of years or the death of the family member. Similarly, if there will be a moment in the future when the commingled trust that’s making the loan divides or distributes, the loan could be due on the earlier of a term of years or the date of the trust division or distribution. At that moment, the loan can be repaid out of the borrower-beneficiary’s separate share, similar to an advancement, without adversely affecting the other beneficiaries.
Appropriate Interest Rate
A key factor in determining the reasonableness of a loan is the rate of return. A minimum rate may not be sufficient to compensate the trust and its beneficiaries.
Internal Revenue Code Section 7872 imposes minimum interest rates—called “applicable federal rates” (AFRs). AFRs are reset each month and depend on the term of the loan. Demand loans without a fixed term are more complicated; a demand loan outstanding for a full year is subject to a blended rate, using the January and July short-term AFRs for that year. Between the two, it will almost always be preferable to choose a term loan. The interest rate under a term loan is fixed for the entire term, making it far easier to administer.
Although not obvious on the face of the statute, practitioners generally agree that IRC Section 7872 and the minimum AFR rules apply to loans by trusts, not just by individuals.2
Charging at least the AFR is important to avoid treatment as a below-market loan. The concept of a “below-market loan” is familiar to practitioners in the context of loans between individual family members; the goal there is to avoid re-characterization of a portion or all of the loan as a taxable gift by the lender. In the context of trust loans, the goal is to avoid an imputed distribution and certain complicated income tax results.
If a below-market loan is made from a trust, Section 7872 appears to require that: (1) the trust be treated as having made a distribution to the borrower-beneficiary in an amount equal to the difference between the actual interest charged and the required AFR. This distribution should carry out taxable distributable net income (DNI) to the beneficiary; and (2) the borrower-beneficiary be treated as having paid interest at the required AFR back to the trust. This interest payment is taxable income to the trust and may be partially offset by the DNI deduction for trust distributions to a beneficiary.
The foregoing is a simplified description of the rules under Section 7872. Tracking and reporting the income tax impact is quite complicated. To avoid these complications, a trustee should always charge at least the AFR.
What about charging morethan the minimum AFR? Charging a higher rate than the minimum AFR —perhaps a corporate bond rate or current mortgage loan rates—may be appropriate to provide a better investment return for the other beneficiaries. A higher rate may also be appropriate to compensate the other beneficiaries for taking personal credit risk in the trust’s investments, as opposed to more conventional types of debt risk (corporate or government).
Factors to consider in setting an interest rate above the AFR include how certain is repayment and how good (easy to seize and sell) is the trust’s collateral. Both impact the loan’s risk and, therefore, the appropriate rate. A riskier loan dictates a higher interest rate.
As the trust’s proposed rate approaches a commercial interest rate, the trustee must ask why the borrower is seeking a loan from the trust at all. If bank loans are available at the same rate, why doesn’t the beneficiary seek a bank loan instead? If the answer to this question is that the borrower-beneficiary is a poor credit risk, this is a red flag for the trustee. The trustee should either decline to make the loan or seek even stronger protections for the trust. For example, a trustee in this circumstance might charge interest at a high junk bond rate and take excess collateral that’s a multiple of the loan amount.
Interest-only loan or amortized? After the rate is set, another question for the trustee is how to structure repayment. Should the loan be fully amortizing over the term of years, or can it require payments of only interest for some period? An interest-only loan for some period of years can be appropriate, although the trustee should analogize to commercial bank loans to determine what’s reasonable and prudent. For example, the interest-only period usually doesn’t extend beyond 10 years under bank loans, at which point combined payments of interest and principal are required.
What about refinancing a loan when interest rates drop? Trustees are often confronted with yet another question on the subject of interest rates; namely, what if interest rates decline during the loan term, and the borrower asks for a rate adjustment?
Refinancing is commonly done under the following rationale: If the loan terms allow for prepayment without penalty, the borrower can choose to prepay at any time with funds borrowed elsewhere at then-market (lower) rates, so why not allow the borrower to renegotiate the loan directly with the trust? There’s precedent for these transactions in the market, as homeowners frequently refinance their mortgage loans with commercial banks when interest rates drop.
However, beware that frequent refinancings could suggest that the loan isn’t a “true” loan, but instead a disguised trust distribution. (In the person-to-person intrafamily context, frequent refinancings risk recharacterization of the loan amount as a disguised gift.) In addition, there remain all the same concerns already discussed—is the new reduced rate fair to the other beneficiaries?
To mitigate these concerns, the prudent trustee often requires some amount of consideration from the borrower-beneficiary to compensate the trust for refinancing at a reduced interest rate. For example, the trustee may require a partial repayment of principal by the borrower at the time of refinancing or may shorten the existing loan term.
While loans to beneficiaries of irrevocable trusts are possible, a trustee should tread carefully. By following the advice laid out above, a trustee can reduce the risk of liability when a loan request arises.
Endnotes
1. M.G.L. ch. 203E, Section 816(18).
2. See, e.g., Stephen R. Akers and Phillip J. Hayes, “Estate Planning Issues With Intra-Family Loans and Notes,” 38 ACTEC L.J. 51, at p. 72 (2012) (“Section 7872 is not limited to loans between individuals, and the concepts of §7872 appear to apply to loans to or from trusts, although there is no explicit authority confirming that conclusion.”)