Ken and Barb have a joint trust that provides for one another and upon the death of the survivor of them the trust is to be divided among their four children. One child, Amy, borrows $300,000 from her parents to purchase a home. She signs a promissory note and a mortgage is recorded. The note is payable back to Ken and Barb. Ken and Barb don’t tell their estate planning attorney about this transaction.
Many years later both Ken and Barb are deceased and their estate is being administered. The children find out about the note, as Amy was the only person who knew about it. None of the note had been repaid.
“I have to tell all of you that we need to open a probate estate,” the estate attorney tells the family.
“Why is that?” David, one of the other children, asks.
“Because the note is not owned by your parents’ trust,” the attorney instructs. “So it is a probate asset.”
“Mom and Dad told me that they were going to cancel the note when they died,” Amy said.
“Well, there’s nothing in their will or trust that directs the note be cancelled,” the attorney says, leafing through the legal documents. “So the note is an asset of their estate to be distributed in accordance with its terms. Even so, if your parents wanted you to not repay the estate, they should have directed the note be distributed back to you rather than cancel it.”
“Distribute back to me and cancelling it sounds like the same thing,” Amy said.
“Not really,” the attorney continued. “Under our income tax laws cancelling a note results in taxable income to the debtor. So you would have had a $300,000 addition to your net income if they cancelled it. The better thing would be to distribute the note back to you as a part of your share, which is what I’m going to suggest that we do during the trust administration.”
“Didn’t you say that the note was part of Mom’s probate estate?” David asks.
“Yes, it is. Your mother’s will is known as a ‘pour over will’ which means that upon the conclusion of the probate administration it will become part of the trust. One option is to divide the note into four shares and distribute 1/4 of it to each of you. Amy would not have to repay herself but she would have to repay each of you your share, which would amount to $75,000 plus interest each.”
“Is there an alternative to that?” Amy asks.
“Yes, you could take the entire note as a part of your share. Since your parents’ estate is $2 million including the note, that means each of you is entitled to $500,000. Amy will receive her $300,000 note plus $200,000 of other assets. Everyone else gets $500,000.”
“I thought that Mom and Dad wanted me to receive 1/4 of everything they had.” Amy said.
“Well, you are receiving 1/4 of what they had at the time of their death, including the note,” the attorney replied.
Often clients don’t consider the outstanding notes that they have between themselves and their adult children. The issue becomes more complicated when the loan is to a child’s business or from the parent’s business.
When you loan money to your children, it’s always a good idea to inform your estate planning attorney to ensure that your intent is properly followed through. Another issue that arises is when the note is never repaid, including interest. The IRS requires individuals to impute an interest rate if one isn’t stated. The interest rates are based on a monthly table that the IRS publishes known as the Applicable Federal Rate (AFR). The AFR changes based upon whether the note is short, medium or long term.
Even if the borrower doesn’t repay the note including interest, in related party transactions the lending parent is supposed to recognize the interest at the stated interest rate or lowest AFR available if no interest rate is provided.
Make sure that your estate plan considers all of the issues associated with lending money to children or other relatives. Otherwise your children might have to sort through these problems which can cause conflict among them.
The Sheppard Law Firm is located in Fort Myers and Naples by appointment.
© 2016 Craig R. Hersch. Originally published in the Sanibel Island Sun.