How to Treat Loans to Loved Ones in Your Estate Plan

Many parents loan money to their children. Some expect payback, others don’t. The loans might be for a down payment on a home, funds to start a business, or in many cases, ongoing support is needed to support a child with money for necessities like food, clothing, and shelter.

What to do about these loans in your will or trust? Should they be treated as part of the child’s inheritance? Forgiven? Still in effect at your death so the child must repay the estate? How you answer these questions is important. Even more so, how these provisions are drafted into your estate plan can have an adverse economic effect on the child who makes the notes, and in some cases, rip sibling relationships apart.

As an example, I’ve recently come across several provisions that look like this; “Any loan that I’ve made to my daughter Jean shall be forgiven.”

What’s wrong with that? First, under our federal income tax law, when you forgive a loan to anyone, then the borrower (in this example, Jean) must recognize as taxable income the outstanding amount of the note. If the original note included interest, then the compounded unpaid interest plus principal becomes taxable income. An unpaid $100,000 note bearing interest at 5% over 10 years compounds to $164,710. If Mom writes in her will that she forgives this note, Jean must recognize that amount as taxable income.

Bad result. I’ve seen this not only in self-made wills, but also in wills and trusts drafted by attorneys.

What about loans that don’t bear interest? The IRS has a rule that says the lender must impute interest on his or her tax return. The interest rate is calculated using the Applicable Federal Rate table that the IRS publishes every month. A non-interest-bearing note also poses difficulties in determining the ultimate distribution to the estate beneficiaries.

The better way to deal with loans is to give them back to the beneficiary/borrower. In my example above, if Mom’s will directs the personal representative to give Jean back her note, that is effectively a $164,710 bequest. Now the issue becomes whether this is counted towards Jean’s share. Assume that Jean has a brother, Tim. Mom’s estate is $500,000 which is to be divided equally. Jean does not have to recognize the note as taxable income (it’s not forgiven – it’s a bequest) but is silent as to whether the note should be counted as part of Jean’s inheritance, then she and Tim each would receive $250,000.

If, on the other hand, Mom’s will directs the personal representative to treat the note as part of Jean’s share, then Mom’s total estate is $664,710.00 ($500,000+164,710). Each share is therefore $332,355. Jean receives $167,645 of cash and her note back. Tim gets $332,355 of cash.

But let’s further assume in a different example that at Mom’s death she has only $100,000 of cash and nothing else. Should Tim get the entire amount? If Mom’s will says nothing about the note, which is an asset of the estate, her total estate would be $267,645 (the note plus the $100,000). Here each beneficiary gets half, $133,822.50. For Tim to be treated fairly, he would get the entire $100,000 and Jean should pay him $33,822.50 from her own funds.

This example also stresses the importance of drafting proper promissory notes. I’ve seen many people do it on their own on a piece of paper. These notes often don’t indicate whether interest is to be charged, when the note is to be repaid, whether interest is compounded, or how often it is compounded (monthly, annually?). In my example, Jean’s note, if not compounded but is charged as “simple” interest would be $150,000 rather than $164,710. Unpaid simple interest is not added to principal, as opposed to compounded interest which is.

On the other end of the spectrum, what if Mom has a taxable estate, one where federal estate tax will be due. A promissory note is an asset of the estate. Should the note bear its proportionate burden of the estate tax? Typically, specific bequests (“I give Jean any promissory note that she has made with me” is an example of a specific bequest) do not bear the burden of estate tax but are taken “off the top” and charged against the decedent’s exemption. Is this fair to the other beneficiaries?

Hopefully after reading this, you see the importance of proper planning. These issues tend to rip families apart, especially when one child has received a disproportionate amount of money relative to her siblings. Poorly drawn promissory notes and estate planning documents can be a bad combination for everyone.

© Craig R. Hersch. Learn more at floridaestateplanning.com