Is one of your top estate planning goals to provide your family with financial security at the lowest tax cost? Strategies to consider include making gifts during your lifetime or bequests at death, or creating trusts and naming your loved ones as beneficiaries.

You could also make an intrafamily loan. This type of loan — where one family member lends money to another — can be an effective way to transfer wealth, provide financial support or assist with major purchases, such as a first home or a business startup. However, this strategy isn’t without drawbacks.

Why choose one?

A key benefit is flexibility. Families can often offer better loan terms than banks, such as lower interest rates, more forgiving repayment schedules and fewer fees. Intrafamily loans also keep money within the family rather than paying interest to outside lenders, which can help preserve family wealth. In addition, when properly structured, these loans can serve as a tax-efficient way to transfer money while still requiring accountability from the borrower.

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 an intrafamily loan doesn’t enable the lender 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 on the lender’s death, that forgiveness will be treated as a taxable transfer.

Will the IRS treat it as a gift or loan?

To enjoy the benefits of an intrafamily loan, it’s critical to treat the transaction as a legitimate loan. Otherwise, the IRS may determine that it’s a disguised gift, which can trigger negative tax consequences (assuming you’re subject to gift and estate taxes). Generally, the IRS presumes intrafamily transactions are gifts. So, to ensure that a loan is treated as a loan, you must take steps to demonstrate that you and the borrower have a bona fide creditor-debtor relationship.

To decide whether a transfer of funds is a loan or a gift, the IRS and courts consider the “Miller” factors. A transfer 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. Additionally, the courts generally consider an actual expectation of repayment and intent to enforce the debt as crucial to determining whether a transfer constitutes a loan.

What are the drawbacks?

Although an intrafamily loan can be a helpful tool, families should carefully weigh the financial and emotional risks before proceeding. A significant risk is personal — mixing money with family relationships can create tension. If a borrower struggles to repay, the lender may feel taken advantage of, while the borrower may feel pressure or resentment.

If you’re considering making intrafamily loans, it’s important to observe the formalities associated with bona fide loans to ensure the desired tax treatment. Contact us for additional details.

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