What’s the Best Way to Go with Loans to Family?

Loans to family must be treated like real, enforceable loans to third parties if you don’t want to run afoul of gift and estate tax.

Loans are a terrific way for parents to foster a child’s independence, encourage responsibility and signal their confidence that their child can succeed on their own.  They also don’t use any of your lifetime gift tax exemption ($11.58 million per person).  But, loans to family highlight some important tax and family concerns you should be aware of.

Kiplinger’s recent article entitled “Gifts vs. Loans: Don’t Be Generous to a Fault” tells the story of Mary Bolles. The case illustrates that parents’ actions and expectations as to repayment of the loan can recharacterize the “loan” to a taxable “gift.” That can mean unintended gift tax consequences. Mary was the mother of five who made numerous loans to each of her children. She kept copious records of each loan and any repayments. Between 1985 and 2007, she loaned her son Peter about $1.06 million to support his business ventures — despite the fact that it soon was clear he wouldn’t be able to make any more payments on the loans. None of the loans to Peter was ever formally documented, and Mary never tried to enforce the collection of any of the loans.

In late 1989, Mary created a revocable living trust, which specifically excluded Peter from any distribution of her estate when she died. While she later amended her trust to no longer exclude him, she included a formula to account for the “loans” he received in making distributions to her children. After her death, the IRS said that the entire amount of the loans, plus accrued interest, was part of her estate. They assessed the estate with a tax deficiency of $1.15 million.  The estate said the entire amount was a gift.

At trial, the court considered the factors to be weighed in deciding whether the advances were loans or gifts. Noting that the determination depends not only on how the loan was structured and documented, the court also explained that in the case of a loan to family, a major factor is whether there was an actual expectation of repayment and intent to enforce the debt.

The court compromised and held that any advances prior to 1990 were loans (about $425,000), since the evidence suggested that Mary reasonably expected that Peter would repay the loans, until he was disinherited from her trust in late 1989. The court said that the money given to Peter after he was disinherited — from 1990 onward — were gifts.

The decision shows that if you’re considering taking advantage of the elevated gift tax exemption before it sunsets, review any outstanding family loan transactions. You should see the extent to which those loans may have been transmuted into gifts over the years—which may adversely impact the amount of your remaining available exemption. The safest way to do this would be to consult an experienced estate planning attorney, who can help you safely navigate these complex rules.

When making a gift there are other considerations.  If you will make such a loan, treat it as such.  Have a lawyer prepare a loan agreement.  Create a reasonable expectation that the loan will be repaid and that you’ll enforce it.  This isn’t just for tax reasons, it is to maintain family harmony.  Giving a “loan” to one child may not sit well with the others, so make sure it is honored.  You should also consider the impact this will have on state taxes, income taxes, and long-term care planning if relevant to you.

To be safe, follow these simple steps:

  1. Document the loan transaction between the lender and borrower.
  2. Charge interest based on the government rates (AFR), which are published monthly.
  3. Make sure the borrower will have enough net worth to likely repay the loan.
  4. Get a copy of the borrower’s financial statement.
  5. If the loan sets out periodic payments, make certain these are made on time.
  6. Report the interest income you receive from the borrower on your income tax return.

Make sure that you do any intra-family loans properly to avoid any future issues.

Reference: Kiplinger (Oct. 7, 2020) “Gifts vs. Loans: Don’t Be Generous to a Fault”

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Estate Planning for Non-U.S. Citizens

A non-U.S. citizen owning property in the U.S. needs an estate plan.
There are a number of special estate planning issues a non-U.S. citizen needs to consider.

The United States has experienced a surge in immigration since 1970, and there are now approximately 45 million foreign-born people living in the United States. Some of them have become U.S. citizens, but many non-citizens live in the United States as well. See https://www.dhs.gov/immigration-statistics/special-reports/legal-immigration. Like U.S. citizens, it is essential for non-U.S. citizens to have estate plans in place. But there are also a number of special issues non-U.S. citizens need to consider.

Common law vs. civil law

There are many differences in the law between countries such as the United States and the United Kingdom, which have common law systems, and countries such as Germany, France, or China, which have civil law systems. For example, common law countries recognize trusts, but civil law countries do not.

In addition, common law and civil law countries have different rules regarding which country’s law will apply (e.g., in a common law country, the jurisdiction where real estate is located governs its disposition, but under civil law, the law of the country of the deceased person’s nationality or habitual residence may be the governing law).

These differences (and there are many more not discussed here!) must be taken into account in determining the best options for estate planning involving property located in other countries.

Wills and trusts

In the United States, wills and trusts are some of the instruments most commonly used by individuals to distribute their money and property. However, when a non-citizen owns property in other countries, the law of the country where the property is located may affect how it is distributed. In addition, if the property is located in another country, that country may not accept a United States will as valid. Some foreign countries may recognize it if it satisfies all of their legal formalities. However, other countries never recognize a will drafted in another country or recognize it only in certain special situations.

As a will created in the United States may not be legally valid in other countries, it may be necessary to have multiple wills, each one dealing only with money and property located in that country (and drafted by someone familiar with the local law). In addition, it is important for special care to be taken to make sure that none of the wills unintentionally revoke any previously drafted wills from another jurisdiction.

Tax Considerations for Non-Citizens

Property located abroad taxed in U.S. for U.S. residents

U.S. citizens, and non-citizens who meet the IRS’s definition of a “resident” of the United States, are subject to federal gift and estate taxes on all of their money and property, worldwide. However, U.S. residents can also benefit from the $11.58 million lifetime gift and estate tax exemption and the $15,000 gift tax annual exclusion. In general, a non-citizen is a permanent resident if he or she currently resides in the United States and intends to remain there indefinitely.

Different rules for non-residents

For non-residents, i.e., non-citizens who do not intend to remain in the United States, only money and property “situated” in the United States is subject to estate and gift tax in the United States. However, their estate tax exemption drops from $11.58 million to $60,000, which could result in a very large estate tax bill if the non-resident has a lot of property located in the U.S. Moreover, they may also be subject to estate tax in their country of citizenship, raising the issue of double taxation. The United States has entered into an estate and/or gift tax treaty with a limited number of countries allowing a citizen of one of the treaty countries who owns property to avoid the possibility of both countries taxing the same asset at the time of death.

Special rules for non-citizen spouses

Unlimited marital deduction not available. A U.S. citizen who is married to a non-citizen should keep in mind that the unlimited marital deduction is not available for gifts or bequests to non-citizens, even if the spouse is a permanent resident. If the spouse receiving the assets is not an U.S. citizen, the tax-free amount that can be transferred to a spouse is only $157,000 a year (in 2020).  However, the unlimited marital deduction is available for transfers from a non-citizen spouse to a citizen spouse.

Tip: A non-citizen spouse can inherit from a U.S. citizen spouse free of estate tax if the U.S. citizen creates a special trust called a qualified domestic trust (QDOT). The U.S. citizen can leave property to the trust, instead of directly to the non-citizen spouse, with special rules applying as to who can be Trustee and how distribution may be made.

Estate planning for non-U.S. citizens is very complex. If you are a non-citizen or are married to a non-citizen, an experienced estate planning attorney can help you think through all of the issues that may affect how you plan for the future.

This article references that wills and trusts are commonly used in the United States to transfer assets at death. If you are interested in learning more about Wills and living trusts see https://www.galliganmanning.com/will-vs-living-trust-a-quick-and-simple-reference-guide/

 

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When to Update your Estate Plan?

Waiting too long to update an estate plan may lead to bad plans and hurt families. Here are some milestones when you should consider changes.

Many people say that they’ve been meaning to update their estate plan for years but never got around to doing it.   Our office is located near the hospital system, so we get a lot of calls for last minute changes, which is difficult, and sometimes not possible.  Worst of all, we occasionally have to probate out of date wills or administer old trusts that left complicated, unnecessary tax planning, unsuitable executors or trustees, or in some cases, beneficiaries the client meant to change, but never did.

As a way to avoid those scenarios, this blog will talk about when you need to review your estate plan.  This isn’t exhaustive and the best approach is to review the plan every few years, but these major life events often indicate a need to change your plan.  The list as follows comes from Kiplinger’s article entitled “12 Different Times When You Should Update Your Will” and gives us a dozen times you should think about changing your estate plan, as well as a few more of my own:

  1. You’re expecting your first child. The birth or adoption of a first child is typically when many people draft their first estate plan. In Texas the designation of a guardian for the child happens outside a will, but it is still important to provide a trust and trustee for that child in your estate plan as well.
  2. You may divorce. Update your estate plan before you file for divorce, because once you file for divorce, your estate plan and assets may not be able to change until the divorce is finalized. Doing this before you file for divorce ensures that your spouse won’t get all of your money if you die before the divorce is final.
  3. You just divorced. After your divorce, your ex no longer has any rights to your estate (unless it’s part of the terms of the divorce). However, even if you don’t change your estate plan, most states have laws that invalidate any distributive provisions to your ex-spouse in that old will. Nonetheless, update your estate plan as soon as you can, so your new beneficiaries are clearly identified and that any obligations created in the divorce are fulfilled.
  4. Your child gets married. Your current estate plan may speak to issues that applied when your child was a minor, so it may not address your child’s possible divorce. You may be able to ease the lack of a prenuptial agreement by creating a trust for your child in your estate plan to keep those assets out of the marriage.
  5. A beneficiary has issues. Estate plans frequently leave money directly to a beneficiary. However, if that person has an addiction or credit issues, update your estate plan to include a trust that allows a trustee to only distribute funds under specific circumstances.  It is often a good idea to create such a trust anyway in case issues arise in the future.
  6. Your executor or a beneficiary die or are incapacitated. If your estate plan named individuals to manage your estate or receive any remaining funds, but they’re no longer alive or suffering bad health, you should update your entire estate plan (especially powers of attorney).
  7. Your child turns 18. Your current estate plan may designate your spouse or a parent as your executor, trustee or other fiduciary, but years later, these people may be gone or not suitable. Consider naming a younger family member to handle your estate affairs.
  8. A new tax or probate law is enacted. Congress may pass a bill that wrecks your estate plan. Review your plan with an experienced estate planning attorney every few years to see if there have been any new laws relevant to your estate planning.  It is also a good idea to keep reading blogs like this one as we try to address significant changes that might affect you.
  9. You receive a financial windfall or loss. If you finally get a big lottery win or inherit money from a distant relative, update your estate plan so you can address the right tax planning. You also may want to change when and the amount of money you leave to certain individuals or charities.  Similarly, a significant financial loss may mean you can jettison unnecessary tax planning and can simplify your plan.  I find many people change their minds on beneficiaries if they think they will leave less money as well.
  10. You can’t find your original estate plan. This happens more than people realize.  If you cannot find your original Will or other estate planning documents, you should consider executing a new one.  First, if you can’t find it that typically indicates it’s so old it needs updating anyway, but in the case of wills you should probate the original.  It is sometimes possible to probate a copy, but that isn’t a given and you should avoid that scenario.
  11. You purchase property in another country or move overseas. Some countries have treaties with the U.S. that permit reciprocity of wills, but how well that works is another matter.  Transferring property in one country may be delayed, if the will must be probated in the other country first. Ask your estate planning attorney about how to address property in multiple counties.
  12. You relocate to a new state.  Estate plans don’t always need to change when you relocate, but there are nuances to each state’s estate and tax laws, so you should consult with a local attorney after you move.  For example, Texas is a community property state that changes how property is owned going forward for married couples and has no estate tax.  A new resident coming from a common law property state with a state estate tax like New York might benefit from a new plan.
  13. Your feelings change for someone in your estate plan. If there’s animosity between people named in your estate plan, you may want to disinherit someone or change your estate plan. You might ask your estate planning attorney about a No Contest Clause that will disinherit the aggressive family member, if he or she attempts to question your intentions in the estate plan.
  14. You get married (or remarried).  One milestone I like to point out that a surprising number of people don’t consider, is updating your estate plan after you get married or in the event you remarry.  Many people assume that their spouse becomes an automatic beneficiary of their estate plan, which isn’t true, although all states give some rights to the new spouse.  It is far better, especially in a second marriage where step children are involved, to update your estate plan to exactly what you want for you and your loved ones.
  15. Your own bad health.  One milestone I’m particularly sensitive to is your own bad health, especially cognitive health such as dementia or Alzheimer’s.  Many clients prepare plans when they are young that aren’t considering long term care, Medicaid or other planning, so that should be complete before incapacity prevents it.

Reference: Kiplinger (May 26, 2020) “12 Different Times When You Should Update Your Will”

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