Lending to family members may be better than setting up trusts

Although controversial and sometimes challenged by the IRS, lending money to family members can reduce taxes on accumulating funds. Loans can replace more cumbersome (and expensive) trusts to shift income-producing assets to another person with a low-income tax exposure.

Shifting income from a high-bracket family member to a child or aged parent provides more spendable dollars to the family member. Accumulating a college fund for growing children is one obvious example. Suppose you have $20,000 in a money market mutual fund earning 16 percent, and you are in a 50-percent tax bracket. Gross earnings from the $20,000 at the average yield of 16 percent would total $3,200, and you would pay 50 percent of that, or $1,600 in taxes.

You could lend the $20,000 on a demand note to your children -- $10,000 to a son and $10,000 to a daughter, both claimed as dependents. Each child invests the $10,000 through a custodian account in the same money fund and earns $1,600 in interest. Because the $1,600 represents passive income and exceeds the $1, 000 limit, each child will need to file a personal income tax return. Thus, in this example, $3,200 can be accumulated in a college fund by switching assets to the children instead of the father's collecting the income and paying $1,600 in taxes at his marginal tax rate. This process can be repeated for several years or until compounded earnings are generating income of their own equivalent to college expenses. The father can call the loan and shift the assets back to his control at any time.

One essential in this plan to shift income is to make sure the loan agreement is a demand note and not a term loan with a specific maturity date.

Anyone wishing to shift income to a family member to reduce or avoid income tax payments is advised to check with a tax lawyer. The form of the note and its provisions should be carefully drawn, as the IRS has not fully agreed with this idea even though recent court cases have supported the concept of intrafamily interest-free loans. In all cases the loans must be bona fide notes of indebtedness written in formal style and legally collectible.

You may find it desirable to call the loans periodically, and if desired, replace them with loans of greater or less value. For example, as the collected funds owned under a custodial account by a child grow, portions of the original capital may be called back by the lending parent or other family member.

Also remember that the accumulated earnings from the lent capital belong irrevocably to the child or other person. If owned by children, the funds cannot be used for their support -- food, housing, or clothing. Further, if the children should decide not to use the collected earnings to attend college, there is nothing the parents can do legally. The collected cash represents their own earnings from borrowed capital and may not be withdrawn.

Loans to family members avoid the 10- year time limit required for the transfer of assets in a reversionary or Clifford trust. Loans may be called at any time should the parents need the assets.

Borrowing funds to lend to children or others may also be feasible. Interest on borrowed funds becomes a legitimate deduction -- up to certain limits that should not inhibit most intrafamily loans. When borrowed funds are lent, they are not gifts and are not susceptible to gift taxes. In fact, loan documents must be drawn astutely to avoid the suspicion that they are gifts.