Coming up - a high court ruling on interest-free college loans
Thousands of high school seniors are waiting to see how they did on the Scholastic Aptitude Tests they took Dec. 3, wondering if their scores will be good enough for the college of their choice.
Meanwhile, their parents may be looking for the most efficient way to finance that education, particularly if they're concerned about cutting taxes.
One strategy often used by parents who have the means for it is the interest-free demand loan. The Internal Revenue Service, however, has never looked kindly on this device, seeing it as little more than a maneuver to avoid gift taxes.
When parents make an interest-free demand loan, they often put the money into a trust established for the child's benefit instead of loaning the money to the child directly. The money might be invested in high-yield securities or money market accounts, and the income is taxed at the child's lower rate.
At the end of the term, say after college graduation, the parents exercise their right to recall the loan and the principle is returned, without interest.
For more than two decades the IRS has fought the interest-free loan in the courts and has almost always lost. The latest legal skirmish took place in the United States Supreme Court where, on Nov. 1, arguments were heard on the gift-tax issue. A ruling is not expected until sometime next spring. Even if the IRS should lose, it is expected to ask Congress to change the law.
''I think the days of the interest-free loan are numbered,'' says Greg Confair, president of Sigma Financial Inc., a financial planning firm in Whitehall, Pa. ''It really is a sham, when you think about it.''
Certainly the IRS would heartily agree, but there are ways to accomplish the same purpose that meet even that agency's standards. Instead of an interest-free loan, it is possible to make outright gifts without triggering a gift tax. Gifts to any number of individuals totaling no more than $10,000 each (or $20,000 per year with gift-splitting between spouses) qualify for the annual gift-tax exclusion.
People who still feel they want to make interest-free loans despite the uncertain legal issues can still do so, of course.
''For many people, interest-free loans will continue to make sense,'' says Dale Bizzi, a financial planner with State Street Bank of Boston.
Should the Supreme Court side with the IRS, there would be little risk of adverse gift tax consequences, as long as the interest imputed by the IRS was less than the $10,000 annual gift tax exclusion. Also, ''the court would have to find a way to value the income for gift-tax purposes,'' Ms. Bizzi noted.
There is also the possibility that a pro-IRS ruling might be prospective rather than retroactive. This would disallow only future loans, not those currently in effect.
There is, however, another income-transfer arrangement that is specifically allowed under the Internal Revenue Code: the Clifford Trust, named after a case involving some of the legal principles behind it. Although some of the advantages of Clifford Trusts were reduced as of Dec. 1, they still have some benefits as asset-transfer mechanisms.
With a Clifford Trust, cash or income-producing property can be transferred to a child, elderly parent, or someone else. As long as the trust is maintained for at least 10 years and a day, its income is taxed either to the trust or the beneficiary, either of which should be at a lower rate. At the end of that term, the assets in the trust go back to the grantor.
Here again, the gift-tax exclusion applies. A beneficiary can receive no more than $10,000 a year from the trust without exceeding the gift-tax rule. This means a taxpayer cannot put more than $16,275 a year into the trust (based on a formula using a 10 percent interest rate). Before Dec. 1 the IRS used a 6 percent assumed interest rate, so it was possible to put as much as $22,640 a year into the trust.
Still, Mr. Confair says he is recommending Clifford Trusts to some of his clients. Families with more than one child approaching college, for instance, can benefit from the fact that the trust is in effect for 10 years. By using a ''sprinkling trust'' you can direct the trustee to make payments to your children in relation to their educational needs. Thus an 18-year-old entering college next year and an 11-year-old starting in seven years can both benefit from the same trust.
Whether you use a Clifford Trust or an interest-free loan - especially an interest-free loan, considering the IRS's distaste for it - make the effort to find a competent tax attorney to set up the trust or write the demand note. An experienced professional should alert you to any adverse consequences that may lie ahead, as well as draw up documents that have a chance of standing up to IRS scrutiny.
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