Frequently when advising clients we find out that a client wants to assist one or more family members, either with helping them to buy a home, starting a business, or even paying off student loan debt. Without wading into the issues of the family dynamics between parents and children (or grandchildren), or the potentially perceived unequal treatment between siblings, this will hopefully at least explain the repercussions tax-wise when making assistance available.
Some clients may have the initial thought that they will make a loan to the family member. This could be because they feel the person should not get a free ride, or they should feel some responsibility by paying it back. It could also be because they don’t want others in the family feeling someone got help that they didn’t. Whatever the case may be, for tax purposes this avoids the transfer of funds being deemed a gift to the person.
A brief review of the gifting limits under the estate and transfer tax rules: each person may gift (with no strings attached) to as many people as they wish up to $14,000 per year without biting into their lifetime transfer tax exemption amount. If you give anyone more than that you are required to file a 709 Gift Tax Return declaring how much the value of the gift was, and consequently using up some of that lifetime exemption, to the extent the gift exceeded $14,000. In 2017 that lifetime exemption amount is $5,490,000 to be used during lifetime or at death. Also note that payments made on behalf of someone directly to a school or medical facility do not count as gifts.
So actually making a loan to someone is not considered a gift. Great! Besides the instilling of a responsibility to pay back, and not having this look like free help to the recipient’s siblings, you save from having to file a return. BUT…..you have to actually document this loan with a promissory note, AND you have to charge a reasonable rate of interest. This is usually where we see that clients have not really finished off the job. The rate of interest needs to be at least the federal rate that is published each month, which is currently 2.33%. It can be higher than that as well.
Alternatively, some clients just want to go ahead and make a gift, depending on their situation, and it could be based on the input from their advisors – it may just make sense to do it that way.
But what happens if you make that loan and the borrower never pays it back? And maybe your heart wasn’t really in it to collect? Well, the IRS is likely going to say it was a gift. What if you don’t charge at least the stated low interest rate? The IRS is likely also going to say it was a gift. So the best intentions could end up going the wrong way if this isn’t done right.
At the end of the day it’s probably best to review these plans and intentions with your advisors to make sure you’re doing it A) the right way for tax purposes, and B) to get to the intended result. Using up some of your exemption may not be a bad thing but it’s possible those gifting limits could be used more effectively.
This is not a substitute for tax or legal advice—as always, consult with your personal tax advisor and/or attorney when making decisions about your tax filings and strategies
As Vice President and Senior Wealth Advisor, Greg provides financial analysis to high net worth individuals. He is the author of several articles for various publications and nonprofit organizations on estate and financial planning subjects.