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No-Tax, Low-Cost Way to Help a Grandchild

Last update on: Jun 23 2020
estate planning

You don’t need to give away money or property to help the grandchildren. You can lend to the grandchildren and let them build something with the loan.

Here’s one plan. Lend $50,000 to your grandchild for five years. The grandchild invests the money and earns 10% annually. At the end of five years, the grandchild has accumulated over $80,000 before taxes. The grandchild can repay your $50,000 and still have over $30,000, minus taxes, left as a nest egg. Taxes should be quite low, since the grandchild should be in the lowest tax bracket and the gains should be long-term capital gains. Your cost is the earnings from the $50,000 for five years, and your grandchild has accumulated a nice starter fund after only five years.

This is such an attractive deal for taxpayers at any income level that the tax code puts up a number of hurdles you have to clear.

You are required to charge a minimum interest rate on most loans. If you don’t charge the minimum, then you have a “below market loan” on which a minimum interest rate based on current market rates is imputed.

You might be able to avoid imputed interest rates, because there are several key exceptions.

A gift loan between individuals, which is what we have here, does not have interest imputed when loans between the individuals do not exceed $10,000, and the loan is not used to purchase or carry income-producing investments.

Another important exception provides no imputed interest on gift loans between the individuals that do not exceed $100,000 when the borrower’s investment income does not exceed $1,000. If the borrower’s net investment income does exceed $1,000, imputed interest does not exceed the amount of the borrower’s net investment income.

This obviously is an important exception for loans to grandchildren. You can lend up to $100,000 to a grandchild interest free, and make sure it is invested primarily for long-term capital gains so that there is little or no annual income. If there is annual investment income, be sure to keep track of investment expenses such as broker’s commissions. Those expenses are subtracted to get net investment income. After five years, the grandchild sells enough of the investments to pay you back. There are no tax consequences to anyone, except taxes when the grandchild sells the investment.

Suppose your loan doesn’t meet one of the exceptions and has interest imputed. Even then, the results are not bad.

When interest is imputed, you will be treated as having made a gift to the grandchild equal to the interest that should have been charged but wasn’t. Then you will be treated as though the grandchild turned around and paid you that amount of interest. Since you can give the grandchild up to $10,000 annually free of gift taxes, you aren’t concerned about gift taxes until the imputed interest is over $10,000. If the imputed rate is 8%, for example, you don’t have a gift tax unless the loan exceeds $125,00.

You’ll then have income equal to the amount of the imputed interest, though you won’t receive cash. Suppose the imputed interest is $2,000 and you are in the 40% tax bracket. Your cost of making the loan will be $800 in taxes on phantom income each year.

If you decide to make a gift loan to a grandchild (or any other relative), you’ll have to handle things properly. The IRS doesn’t like loans between related parties and tries to treat them as gifts. Two recent Tax Court cases show how to avoid this problem.

You must show that the transfer was intended as a loan with a real expectation of repayment and an intent to enforce collection. Be sure that a note is signed by the borrower or an adult guardian. The note should spell out an interest rate and repayment schedule and contain an unconditional promise to repay. The repayment schedule, which can be a balloon payment at the end, must be followed as much as finances permit. There also must be a reasonable expectation that the loan could be repaid. For example, a loan made to a relative with a failing business that is unlikely to recover might be treated as a gift rather than a loan.

In one case, a family construction business was experiencing hard times. The company lent money to the owner’s son, an experienced foreman, so he would be available when new contracts were won. Some payments were made on the loans. But after a few years the son was unemployed with a lot of debts and declared bankruptcy. The Tax Court found that the transactions were loans. The corporation had a reasonable expectation of repayment because there was evidence when the loans were made that the son was likely to obtain employment sufficient to make the payments. (Mann Construction, Inc., T.C. Memo 1999-183)

The other case involved a man who lent money to his brother. The brother’s business was in financial difficulty, but that was expected to be resolved after life insurance on the brother’s late partner was paid. The lending brother sold the loan to their father.  Unfortunately, the borrowing brother was indicted for killing the partner and, though the indictment was dismissed, the insurance company refused to pay benefits on the life policy. The borrowing brother slid deeply into debt and said he was unlikely to ever repay the loan.

The Tax Court treated the transaction as a loan. There was a signed note requiring interest, and both parties treated the transaction as a loan. Also, there was a formal demand for payment. (Barr, TC Memo 1999-40)

If you eventually do not need the loan to be repaid, you can forgive it. That would be treated as a gift to the grandchild at that time, with gift taxes on the forgiveness.

One word of caution is that the assets your grandchild purchases might decline in value. I know one wealthy individual who lent money to a child and suggested that she purchase a stock he knew well. Unfortunately, the market did not agree with his assessment of the stock. The child now owns a stock worth half its previous value and owes her father the money.

No-interest loans are one of the estate planning classics, used by individuals of every net worth. Consider making no-interest loans part of your plan to create a legacy for your grandchildren.

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