Perhaps your prodigal child wants to start a law firm or a medical practice and needs start up funding. You have some money set aside for your children’s and grandchildren’s inheritance but agree to loan them the money out of this fund. It’s not uncommon for these monies to be secured by a promissory note, even though many parents would not strictly enforce its terms. If the promissory note is not paid off by the time the parents pass away, it becomes an asset of the estate that must be accounted for. If it is a significant amount of money, the IRS or state tax authority will impute interest. If the parent decides to forgive the loan, that is usually considered taxable income to the child.
LOAN DOCUMENTS AND ESTATE DOCUMENTS CONTROL
The parent controls these issues and to the extent that it can be controlled during his or her life, they should be. Loans should be in writing, with the repayment schedule outlined. Most loans obtained on the open market have extensive outlines of the remedies that the creditor reserves. These are not necessary unless the parent actually intends to exercise these remedies. If no remedies are outlined in the document, the parent always has the right to document his or her intentions on how the estate should treat these loans.
In many circumstances it is not uncommon for a parent to simply loan money to a child and document the amount loaned and paid back. When this happens, there are no enforceable rights and the money not paid back is essentially a gift.
CANCELLATION OF DEBT OR GIFT
The parent can forgive the loan. As noted above, cancellation of debt can be considered taxable income. If the estate is probated or otherwise documented by, for example, state estate or inheritance tax returns, the IRS can cross reference this information with the debtor child’s tax return to insure accuracy. The parent may even forgive whatever the balance of the loan is at the time of his or her passing. If the balance on the loan is less than $14,000, it can be considered a gift without any tax consequences.
One issue that must be considered if the estate goes through probate is that the creditors get paid first. If the amount to be repaid is large enough the estate may essentially be insolvent due to the unpaid or forgiven debt.
OFFSET
The parent can also decide that if the loan is not fully repaid, the unpaid amount can be offset against whatever amount the child would normally receive. This allows for parent to maintain rather strict adherence to equal shares to the heirs.
DIRECT REPAYMENT
The parent can of course require full repayment of the debt in conformity with the promissory note. The estate would receive the money from the promissory note.
Many of these complications can be avoided in advance by planning and simple adjustments to future plans. Whenever you decide to loan any significant amount of money to an heir you should address this in your estate planning with experienced estate planning lawyers.