Monday, October 3, 2011

Should You Make a Loan to Your Child This Month?


During the month of October is the time to make a loan to you child assuming the child is not subject to the "kiddie tax." Why? Because the imputed interest rate for October is at an all time low and therefore as a planning tool you can move wealth to your children gift and estate tax free.

Generally loans between related parties are governed by the IRS code so that related parties cannot assign income without adverse tax consequences. There is a small exclusion for related parties so that a loan of $10,000 generally does not require that interest be charged.

In some cases if a loan of $100,000 or less is made between related parties there is no imputed interest to the lender so long as the borrow does not earn more than $1,000 from investments. If the borrower earns a greater amount then the lender can be charged with interest income.

Because of the current extremely low interest rate environment making a loan to a child can avoid the imputed interest charge and shift wealth to the borrower.

The following is an illustration of the advantage of making a loan using the low applicable federal interest rates (AFR).

Let's assume that a loan is made to your child $1 million. The loan will require that you use the current applicable rate for a short term loan- 0.16%. A short term loan is a loan with a term of less than three years. Assuming further that the child pays the interest rate due annually of $16,000; after three years a child will pay $48,000.

Now assume that the child invests the $1 million in a market investment returning 4%. At the end of three years the return on the investment will be $120,000. The net benefit to the child is $72,000 ($120,000-$48,000). Now couple this with annual gifts to the child of the current annual exclusion of $13,000 which for two parents is $26,000, the net benefit (and wealth shift) to the child over the three years is $150,000 including gifts. The parent will receive back his or her $1,000,000 plus the earned interest.

This is simple illustration underscores the advantage of making a low interest loan to a child using the current interest rates.

The simple technique when applied to several children can pass wealth at no tax cost (gift or income) to the parents. If the borrower were a trust for the benefit of the child, the net benefit earned on the investment and by way of annual gift can be protected from creditors and be available for the child during his/her lifetime.

Illustration of the advantage of a loan using the current (Oct 2011) AFR

Loan to son/daughter 1,000,000
Interest rate using the short term (0-3yrs) AFR 0.16
annual interest payment* $16,000
Cumulative interest payments $48,000

Assume child invests loan amount @ 4% $40,000
Cumulative return on investment $120,000

Net benefit to child(120,000-48,000) 72,000

*child can make interest payments with annual exclusion
gift from parent.