Lucy loaned her son money over the years. First, it was $75,000 for a down payment on his home then another $40,000 when he was unemployed. Those weren’t the only times she sent money his way. It seemed that over the years he always needed something, and Lucy was there for him.
“I made him sign promissory notes,” she said, “but he’s never made any attempt to pay me back.” Lucy wondered whether this should affect his share of the estate when she updated her plan.
“My daughter has never asked for anything,” Lucy continued, “but she and her husband earn a good living. I’m not sure what to do.”
Lucy’s dilemma isn’t unique. She eventually settled on treating the unpaid notes as a charge against her son’s inheritance. She wanted to even out the shares considering both lifetime loans that were never repaid and testamentary transfers. She felt that although her son was in greater need, both children were able bodied adults. She didn’t want her last statement in the form of her estate plan, to somehow indicate that her daughter wasn’t equally loved.
Lucy’s desire to consider her son’s loans as an advance on his inheritance raises issues. First, Lucy must determine the amount of outstanding debt that exists, or at least consider the amount that she would like to charge against her son’s share. If she can evidence the loans with promissory notes or cancelled checks, all the better, although it’s not necessary since Lucy is free to charge any amount that she believes is fair.
The second issue is whether accrued unpaid interest should be added to the principal balance. When you run the numbers, unpaid interest can exponentially increase the amount outstanding. Consider a $30,000 note at 3% interest over 20 years. If you compound the unpaid interest on an annual basis, the amount owed balloons to over $54,000. Compounding on a more frequent basis, (monthly, for example,) the amount would be even more. There are two ways to calculate the interest, by compounding it as this example illustrates, or simple interest, which adds the interest to the principal balance every year without compounding. In my example simple interest would increase the note to $48,000.
Once that’s settled, there’s the issue of keeping track of any future loans or gifts. Also, if Lucy’s son happens to repay any amounts, a ledger needs to be kept. Lucy probably doesn’t want to amend her estate plan every time the amount changes, so she probably wants to maintain a ledger and reference that in her plan.
This presents yet another issue. What happens if and when Lucy becomes incompetent? I’ve had clients not maintain their ledgers, sometimes for years, which becomes a mess when we try to figure out the amount that should be charged against a share of the estate. An alternative is to indicate a fixed amount in the estate plan, understanding that it might not be entirely accurate when the time comes to settle it.
Who enforces the ledger should also be addressed. If Lucy names her daughter as personal representative and/or trustee to her estate plan, then the daughter delivers the bad news on her brother’s inheritance, unless Lucy has told him ahead of time. Further, if there’s any dispute as to the amounts owed or repaid, the sister must negotiate with her brother about it, with the matter potentially landing in litigation.
Finally, there are tax issues. If Lucy has a taxable estate then the promissory notes are included in her estate as an asset. That speaks to Lucy specifically bequeathing the notes back to their maker, Lucy’s son. What if the son doesn’t have a large enough share to cover the outstanding note values? Must he repay the overage to the estate? Is the overage forgiven?
Also, for income tax purposes Lucy has to be careful not to forgive the notes. Instead, they should be gifted back to her son. Promissory notes that are forgiven constitute taxable income to the maker, Lucy’s son in this example. If, on the other hand, she gifts the notes back to him, they are a taxable gift, but if her estate does not exceed her available exemptions at her death, there’s no tax paid.
Many of these same issues apply if the lifetime transfers were gifts instead of loans. As you might imagine, there’s more to it than initially meets the eye. If any of this applies to you or a loved one, I hope raising this issue helps head off future problems.
© 2021 Craig R. Hersch – learn more at floridaestateplanning.com
