Looking for a tax-efficient way to transfer some of your wealth to your children? Today's low interest rates combined with turmoil in the bond market provide terrific estate planning opportunities. The simplest such strategy is a family loan. Basically, you lend your child money at a low interest rate and the child reinvests it at a higher interest rate.
IRS rules require that interest rates on family loans roughly correspond to interest rates of U.S. Treasury securities, with the IRS calls the "Applicable Federal Rate." For instance, the AFR on loans of three years or less is only 0.83%. It's only a little higher for loans from three years to nine years: 2.15% (for annual compounding).
Corporate bonds have been smashed by the global economic catastrophe. Even the safest corporate bonds often yield 8% or more. The arbitrage opportunity is obvious. Here's a simple example of how it might work. (For sake of simplicity, I've ignored commission costs and assume the bonds are purchased at par.)
You lend your adult son (18 years or older, 23 if a full-time student) $2 million for an eight-year term at a 2.15% interest rate. He uses the money to purchase several investment-grade bonds with an average interest rate of 7.5%. Each year, the bonds earn $150,000 in interest. Your son pays you $43,000 in interest on the loan.
The strategy works because wealthy parents are usually in a higher tax bracket than their children. For instance, if you're in the 35% tax bracket and your son is in the 20% bracket, the net income tax savings is $16,050 annually. Plus, you shift $107,000 annually out of your estate without gift tax consequences, or nearly $900,000 over the life of the loan. In addition, you could give your son back $13,000 of the interest each year without gift tax ($26,000 if both parents made the loan).
What's the downside? Basically, it's investment risk. The company issuing the corporate bond(s) your son buys could default on its obligation. If it does, your son won't have the income to pay back the loan. And if you forgive the loan, the IRS may reclassify the loan as a gift and impose gift tax on it. Fortunately, there are ways to deal with this possibility—but the best strategy is to choose the safest possible bonds.
Copyright © 2009 by Mark Nestmann
(An earlier version of this post was published by The Sovereign Society.)
