Parents and grandparents often give children and grandchildren financial help to purchase a home or to carry them through hard times. It can be a wonderful, generous gesture with a lasting impact across generations of family members. But it can also create strife and intra-family conflict if parents fail to properly document the transfer as a loan.
A transfer from a parent to a child is presumed to be a gift under Illinois law, not a loan. Similarly, to sustain the tax characterization of an intra-family transfer as a loan, the IRS looks for “an actual expectation of repayment and an intent to enforce the debt”. A party can rebut the legal presumption of a gift, but only by introducing clear and convincing evidence – the highest and most difficult evidentiary standard in a civil court proceeding.
An Illinois court recently held that a father did not rebut the presumption of a gift even though he had home equity ac- count statements showing withdrawals, copies of checks made payable to his son and daughter-in-law, and a vehicle lease agreement. The court did not permit the father to introduce into evidence his contemporaneous log of transfers, including dates and amounts, and a spreadsheet summary of the transactions.
What should parents do? The best way to prove that a transfer is a loan is to prepare a written promissory note that includes important terms (such as the amount loaned, the interest rate charged, and the schedule of payments) and then have the child sign it as borrower. A promissory note is a legal document with long-lasting consequences, so it’s best to get professional help from a lawyer.
Parents transfer money to a child before deciding whether to treat it as a gift or a loan, usually based on the mistaken assumption they can “figure it out later.”
Solution: “Figure it out later” is not a viable strategy. Instead, parents should document the transfer to a child as a family loan using a promissory note (and a mortgage under some circumstances).
One attractive option for intra-family loans is to include a low interest rate in the note, known as the Applicable Federal Rate or AFR (the interest imputed to have been paid and received under the Internal Revenue Code). The child is charged the absolute minimum market rate of interest, and the parent can decide each year whether to collect the interest and principal or to forgive up to $15,000 by each parent as a gift to the child without creating gift and estate tax consequences.
Parents make a large gift to Child 1 and, in the interest of equality, want to make sure Children 2 and 3 receive identical gifts during the parents’ lives or after their deaths; however, the parents do not tell their accountant about the gift, and they do not ask their lawyer to update their estate planning legal documents. Solution: For an annual gift exceeding $15,000 from each parent, a Form 709 gift tax return must be filed with the IRS by the gift-giver – or else stiff penalties may result for late filing and late payment.
Always make sure to discuss gifts with your tax and legal professionals. If the parents want to “equalize” gifts to children, they could update their living trusts to include a flexible provision that makes a gift to children after the parents’ deaths, but only if those children did not receive a well-documented gift during the parents’ lifetimes. Not only would this provision elegantly accomplish the parents’ goal of equalizing gifts, but also it would minimize the chance of children fighting about unequal gifts after the parents’ deaths.
If you are thinking about giving financial help to a loved one, please contact your tax and legal professionals before making any transfers.
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