Was William Shakespeare foolish when he penned, “Neither a borrower nor a lender be”? Shakespeare’s counsel was certainly sound in his day. But these aren’t Shakespeare’s times.
Instead, perhaps we should update an adage of another time, the 1960s. For our purpose, let’s refresh a popular counterculture phrase of the ‘60s, “Make love, not war” and contradict Shakespeare’s counsel. Yes, Make loans, not war.
A Compelling Idea
So, why are these the days to make loans? Specifically, I’m referring to intrafamily loans, like a mother making a loan to her adult child. This idea is currently compelling for many reasons.
Mom can make a loan to Daughter at historically low interest rates – even below 0.5%, with very favorable repayment terms. The modest interest Mom receives on the loan, if structured through a grantor trust, isn’t even income taxable to Mom. Typical loan terms require annual payments (rather than monthly, and interest-only payments, rather than principal). Many intrafamily loans such as these are paid down, over time, with $15,000 annual exclusion gifts from Mom to Daughter or to the trust benefiting Daughter.
Furthermore, Mom’s opportunity cost to make this loan to her daughter is quite low. Because interest rates are low, Mom is probably earning very little on her cash anyway. So, the cost to Mom to help the daughter is negligible.
To make this story more dramatic, let’s place Mom in a low-income tax state, like Florida, Wyoming or Texas, and let’s place Daughter in a higher income tax state, like Illinois, New York or California. For an unexpected plot twist, we’ll have Mom make the loan to a trust for Daughter, rather than directly to Daughter.
Imagine that Daughter prudently and successfully invests the loan proceeds. The taxes generated on the gains from those investments can actually be paid by Mom, if – and only if – Mom wants to pay those taxes for Daughter. For example, Mom can initially pay the income taxes generated by Daughter’s trust, then change her mind in the future and have Daughter’s trust pay any income taxes generated by the successful investments.
What have we accomplished? We’ve removed the earnings on the investments made with the loan from being taxable in Daughter’s high tax state of residence. The income tax savings from this state tax arbitrage can be as high as 13% annually and perhaps even more if warnings of state tax increases prove accurate.
Many parents have said they’d like to see their children enjoy an inheritance without having to wait decades until their parents have passed away. Still, those parents sometimes have a reluctance to irrevocably transfer wealth to the children during their lifetime. How can these two seemingly contradictory desires coexist? That answer is simple. Although the parents want to benefit the children, there’s often a little voice in the back of their brains saying, “Don’t give away your wealth – you just may need it.”
Making a loan is something of a Solomonic way of assisting the next generation, but still keeping a string attached to the loaned funds. Those funds, pursuant to the terms of the loan, must be paid back to the lending parent or parents.
Loans can also address a less common but still troubling situation. There are some parents who have little faith in their child’s new spouse or are skeptical that the marriage will endure. One successful financial baron boasted that he gave a luxury home to his daughter. The baron’s son-in-law was intentionally omitted from the title of the home. The clear, but unstated, message to the son-in-law was that he could enjoy the home only if he stayed in the marriage.
Will the son-in-law be reminded he’s not a king of his castle every time he turns the lock on his wife’s castle door? Has the baron sewed seeds of resentment? Has the baron unwittingly fanned the embers of discontent, making war, rather than love, the more likely outcome?
Let’s contrast the baron’s heavy-handed approach to the strategy of “Make loans, not war.” If the baron had loaned his daughter and son-in-law funds to acquire their home together, both borrowers could have beamed with the pride of ownership in the new home. All future appreciation in the home would benefit both the daughter and son-in-law, motivating them to work harder together. Both homeowners would benefit from every flower planted in the yard and room remodeled. That mutual hard work would make it ever more likely that the baron’s grandchildren will grow up in a two-parent home. If the marriage should fail, the loan would eventually be repaid by both borrowers, so the baron’s balance sheet would have remained intact.
While lending to loved ones is wise, it may not warm the lender’s heart. But every parent will glow with joy to be the cause for a child leading a better life. The loan idea can help the child live in a better home, in a better school district, in a safer neighborhood. The loan can reduce the economic hardships younger married couples face with health and education costs. The leading reason given for the dissolution of marriages is financial difficulties. It’s impossible to quantify the benefits of helping maintain a marriage that might have otherwise unraveled over short-term financial stress.
Of course, we can take the mantra of “make loans” too far. Like Falstaff in Shakespeare’s plays, or the counterculture kids of the 1960s, we can’t go overboard with the free, or nearly free, loan idea. In poor economic times, it could be difficult for Daughter’s trust to fully repay Mom if the investments don’t perform as well as planned.
For that reason, we must practice safe lending and lend responsibly.
Robert Napier is a partner at Harrison & Held LLP, based in Naples, Fla. and Chicago.