Loans to children are a frequent source of family conflict — and often instigate lucrative estate litigation projects for lawyers. Here’s why.
Loan vs. Gift
There is a huge legal difference between a loan and a gift, namely that a gift does not have to be repaid. But loans may gradually mutate into gifts. For example, under Oregon law, a suit must be filed within six years to collect a debt. If no suit is filed, collection of the debt is barred by the statute of limitations. Thus, if a parent makes a loan to a child and takes no collection action for six years, the child has no legal obligation to repay and the loan has effectively become a gift. This has several consequences. First, and most important, the executor is probably barred from offsetting the child’s inheritance by the amount of the loan. In other words, the loan is irrelevant when determining the child’s share of the decedent’s estate.
Estate Tax Implications
For federal and Oregon estate tax purposes, a loan owing to a decedent is considered an asset of the estate. Thus, these “phantom” assets can attract estate tax. In general, a tax examiner will presume that the value of the loan is its face amount (plus accrued interest) absent an appraisal demonstrating a lower value. An appraisal is problematic because the appraiser will have to evaluate the creditworthiness and financial wherewithal of the borrower, and discuss these items in the appraisal. See, Moore and Hungate, Valuation Discounts for Private Debt in Estate Administration, 25 Estate Planning 195 (WGL magazine, 1998).
Income Tax Implications
The income tax consequences of family loans may be simple or complicated. If the loan bears market interest, and the family member makes timely payments on the loan, the parent recognizes interest income and the child recognizes interest expense as payments are made. Simple enough. (In general, the child will not be able to deduct the interest unless the loan is secured by a mortgage on the child’s residence.) The income tax consequences are more complicated if the interest rate is below market, or if the child does not make payments on the loan. Another possible issue is the treatment of the accrued interest if the parent makes a lifetime gift of the note, or if the child inherits the child’s own note at the parent’s death. A thorough income tax analysis is beyond the scope of this article.
Equalizing Other Beneficiaries
Loans are not particularly difficult to handle at a decedent’s death if the borrower acknowledges the loan and sufficient assets are available to equalize the other beneficiaries. For example, suppose (i) Child #1 owes $200,000 to the decedent, (ii) the decedent’s estate is $1M (not including loans), and (iii) there are three children. If the estate is liquid, Child #1 would receive $200,000 cash and the loan, and Child #2 and Child #3 would each receive $400,000. But if Child #1 borrowed $600,000, there is not enough to go around. Child #2 and Child #3 would each receive $500,000, which would still be less than the $600,000 loan. The solution would be to allocate $33,333 of the loan to each of Child #2 and Child #3, so that each child would end up with $533,333 of value. The problem is that there will be friction when Child #2 and Child #3 try to collect from Child #1. In other words, the equalizing $33,333 gifts may cause more harm than good.
In conclusion, a parent should be cautious when making loans to children. In general, the parent should assume that the child will be unable or unwilling to repay the loan. The parent’s quality of life should not be dependant on repayment of the loan. If the loan becomes uncollectible by reason of the six year statute of limitations, the parent should forgive the loan but adjust the child’s inheritance in the parent’s will or trust. If the parent forgets to change his will, the child’s inheritance will not be reduced by the loan, which will infuriate the child’s siblings. Finally, loans should be evidenced by a written promissory note that specifies the interest rate and terms of repayment. Rather than loans, the parent should consider making equal gifts to all children. This avoids the loan vs. gift controversy. Further, the parent does not have to monitor when the loan becomes uncollectible by the statute of limitations, and whether it is necessary to revise the parent’s will or trust.