Updated: Sep 18, 2020
The start of the twenty-twenties will be remembered by the COVID-19 pandemic. The saying “change is the only constant in life” has become our daily reality. We watch a 24-hour news cycle release daily changes to coronavirus models, the financial markets deliver daily volatility, and we all experience the difficulties trying to plan just a few weeks out.
As it relates to planning for the transfer of your wealth, one opportunity is fortunately defined and clear right now . . . the low interest rates you can use to open your family bank. Intrafamily loans ("family bank") allow you to make loans and transfer appreciation to your children and grandchildren. With historically low interest rates, there is an opportunistic window available right now to make these loans. The IRS publishes monthly applicable federal rates (AFR) which define the minimum interest rates to charge for intrafamily loans.
Affluent families should act now and open the family bank. Opening the family bank, in concert with taking advantage of extraordinary transfer tax benefits currently available, will help you shift appreciation to the next generation and help protect your wealth from estate and other related transfer taxes.
How do you open the family bank?
It’s simple . . . work with your advisor to execute a promissory note and lock in the AFR interest rate for the loan. The IRS defines 3 different types of loan interest rates which you can lock in. You can use a short-term rate (loans up to 3 years), (ii) a mid-term rate (loans up to 9 years), or (iii) a long-term rate (loans over 9 years). For May 2020, the AFR interest rates for an intrafamily loan are:
It is helpful to note that this interest rate charged to a trust, a child, or a grandchild can be used for the intrafamily loan regardless of the creditworthiness of the borrower. As the bank, you define the terms and underwriting conditions. You just need to make sure you charge an interest rate equal to or greater than the AFR rate.
Why use intrafamily loans rather than outright gifts?
Intrafamily loans, as opposed (or in addition) to outright gifts, are an effective way to help teach children (Generation II) and grandchildren (Generation III) about investing and having "skin in the game" through making annual loan interest payments and the need to repay the loan in the future. This helps align expectations and instills patience having to watch investments grow in order to repay the principal loan and what's required to generate returns above the interest payments.
Although you can structure the loan for any purpose, we recommend structuring the use of the loan to acquire an asset. The use of loan proceeds to acquire assets like a home, an investment portfolio, or a properly funded life insurance policy are ideal to use with intrafamily loans to children and grandchildren.
Our firm focuses on helping clients acquire and manage the life insurance asset. A life insurance policy can provide additional leverage on the loan as well as a collateral assignment on the policy to protect the principal loan funded from the family bank. This provides additional protection to prevent access to the principal loan. The death benefit component of the policy is also a way to help create additional liquidity if an early death of a child occurs before assets are transferred to Generation II or III.
Our preferred design for intrafamily loans is funding the policy with a single premium. This allows you to make a single loan to your child, and most importantly, to lock in the AFR interest rate today without any future interest rate risk.
What are the benefits of life insurance with intrafamily loans?
Life insurance maintains tax benefits as it relates to tax-deferred growth of the underlying policy cash value as well as an income tax-free death proceeds paid to named beneficiaries. The tax deferral features give the child or grandchild the benefit to not worry about asset growth increasing their tax rate or taxable income each year.
We have analyzed a hypothetical family member to illustrate the leverage that exists to combine intrafamily loans with a single premium life insurance policy.
Hypothetical Scenario: The family bank makes a loan to a son or daughter who acquires a single premium life insurance policy. The policy delivers tax deferred asset growth to a child while providing death benefit protection for his or her family. AND/OR The policy pays a tax-free death benefit to grandchildren upon the death of your son or daughter.
$1,000,000 Single Premium 
Intrafamily Loan (1.15% Interest Rate)
Insured: Male Child Age 50 (Preferred Non-Smoker)
 Separate Account (Variable) life insurance product with an assumed earnings rate of 7% (before insurance charges). The hypothetical results are based on various assumptions, such as underwriting, policy charges and returns. Actual results will depend on formal underwriting and actual policy performance and charges.
 IRR is net of all policy expenses (the loan interest outlay measured against the net of loan surrender value each year).
Important assumptions and risks to consider
With any estate or wealth transfer planning strategy, it is important to think about emotional or relational problems that can be triggered because of an intrafamily loan. It is generally best to run your family bank with open communication and avoid scenarios where any child or grandchild becomes dependent on these loans.
For you and your spouse, the co-founders of the family bank, it is also important that your own liquidity is not dependent on any loan repayment date or annual loan interest payments. Intrafamily loans are best deployed as part of your family wealth transfer plan without any risk to your own financial future or standard of living.
Please contact us to develop a plan now to take advantage of these historically low interest rates and open your family bank.
This is not an offer to sell a security or insurance product. This information is provided for informational purposes only and should not be construed as legal or tax advice. You should discuss your circumstances with a financial professional before making any decisions. This material and the opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual. https://www.trcfinancial.com/disclosure