Family Loans for Tax Savings

The 1986 tax law introduced the basic rule that when someone (usually a parent) makes an interest free or low interest loan to a child, the parent will be treated as having received interest income equal to the federal interest rate on short term obligations. The child will be treated as having an interest expense, so that if assets are used to invest in income producing investments, the interest expense can be used to reduce the amount of the income - after working through the mechanics of the deduction for investment interest. The object of the 1986 law was to put the parent and child (or other related parties) in the same economic position they would have been in if the loan had not been made. In addition, the amount of forgone interest is treated as a gift from the parent to the child and uses up part of the annual gift tax exemption.

However, the rules are not as restrictive where a child with assets loans those assets to a parent at a zero interest rate or at a low rate of interest.

First, if the loan is never more than $11,000 at any time during the year and if the money is not used to earn investment income, then the result is treated as a “de minimus” exception. Where the funds are used to pay for living expenses or medical expenses, it would not be necessary to charge any interest on the loan.

The second exception is that where a gift loan is made between individuals for an amount of less than $100,000, the amount of the imputed interest to the lender is limited to the amount of the investment income earned by the borrower. And if the net investment income of the borrower is less than $1,000 in any year, then the net investment income is treated as if it were zero. Again, if the money is used to pay for medical or living expenses, there would be no income imputed to the child (lender).

At some point in time, the parent might decide to liquidate his or her assets and would then be in a position to repay the loans or the loans could be repaid by the parent's estate.

What is the benefit of this arrangement as compared to simply spending down the money of the parent? The loans reduce the investible income of the higher bracket child. Meanwhile, the parent's funds continue to be invested but they accumulate without being subjected to as high a tax bracket. Basically, it's a method of bracket transfer. The parent's low tax bracket is substituted for the child's high tax bracket.  is it worth the trouble? That clearly depends on the amount of funds that are loaned to the parent, the rate of return on the parent's savings, the differential in the rate of income tax for the parent and the child and the number of years that are involved. But it could certainly add up to a lot more than pocket change.

However, it could become a very complicated problem if there are multiple children involved. It would work best where there is only one child who is the only heir of his or her parent.

Copyright, 2003, Vernon K. Jacobs

Vernon Jacobs is the Editor/Publisher of The International Wealth Protection Reports, which are a collection of research reports on legal methods of asset protection and tax avoidance. Further information on this subject is available at http://www.offshorepress.com/  Jacobs is a CPA who has worked as a free lance tax and financial author/editor since 1977. Details about his credentials and experience are online at http://www.offshorepress.com/vkjcpa/

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