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Using An Unsecured Loan to Avoid Gift Tax

Estate planning is among the most important areas of tax strategy. It was recently impacted by the Tax Cuts & Jobs Act (“Act”) when the estate tax exemption was increased.  The Act increased the estate tax exemption from $5.5 million to $11.18 million.  Nonetheless, it’s still wise for people to keep up with changes to the law for long-term estate planning. That’s because, the U.S. still imposes a federal estate tax on estates with values above the exemption.  The current maximum tax rate for estates is a hefty 40%.  Accordingly, it’s clearly in the interest of affected individuals to engage in appropriate estate planning as much as possible.  

Currently, the U.S. government requires donor estates report and include gifts above a certain amount. Hence, the “estate tax” is essentially a deferred gift tax.  It prevents wealthy individuals from simply avoiding the estate tax by making sizable gifts prior to passing away. Depending on the situation, an individual can elect to pay the gift tax up front immediately after making the gift.  Most of the time, however, the estate includes the excess gift amount.  When that happens, the applicable tax is paid together with the remaining estate tax.

Tax Planning Mechanics With An Unsecured Loan

Given this timing issue, there’s actually a tax strategy that can come into play.  It’s actually a clever method to make sizable gifts and not report the gifts.  This has the effect of leaving them out of a decedent’s estate.  The method involves the creation of an unsecured loan which is “paid back” by the borrower over time.  During the payback period, the lender makes periodic gifts to the borrower, in amounts below the annual gift exclusion.  The aggregate amount of these gifts are thereby gradually removed from the lender’s estate.  

This post will discuss the mechanics of this estate planning tax strategy.  It will also emphasize why this might be a useful tool for individuals impacted by the federal estate tax. 

Estate and Gift Tax Rules

When someone dies, their estate faces a federal tax liability on its value in excess of the current estate tax exemption.  As referenced, that exemption amount is currently $11.18 million. So, for example, if an individual dies owning $20 million, the nearly $9 million above the exemption will be taxable. The gift tax was developed to prevent wealthy individuals from circumventing the estate tax.   It does so by imposing a tax on large lifetime gifts.  Suppose that the $20  million net worth individual in our example simply made gifts aggregating $9 million. Without the gift tax, the gifts pass tax free.  That enables the individual, and consequently, his or her beneficiaries, to avoid an estate tax altogether. 

The tax code provides both a gift tax but also an annual exclusion for gifts. This means that if a gift doesn’t exceed a certain amount, $15,000 in 2018, there is no reporting requirement. The exclusion effectively takes the gift out of the donor’s estate. In other words, if a person makes a gift of $14,999 to someone, that amount is removed from the donor’s estate.  That’s because the reporting requirement isn’t triggered by amounts below $15,000.  The net effect is as if the money had always belonged to the recipient for estate and gift tax purposes.  

Unsecured Loan Planning Examples

But what if a person wants to make a sizable lifetime gift and avoid having it included in their estate? There is a way to accomplish that goal.  It requires a bit of effort, though, from both the donor and the recipient. Instead of making an outright gift to the recipient, the donor can make an unsecured loan, using a promissory note. The recipient is then free to spend the money however  he or she sees fit. The recipient can then “pay back” the loan with periodic gifts from the lender.  The gifts would be in amounts below the annual exclusion and made regularly during the life of the loan.

Here’s an example: suppose an individual wants to divest $250,000 from his estate to minimize estate taxes. The individual makes a loan to a beneficiary for the $250,000. The beneficiary uses the loan to fund whatever enterprise or activity he or she wishes.  That beneficiary then “repays” the loan using regular gifts from the lender. Let’s suppose that the lender makes regular gifts of $14,000 to the beneficiary. It, therefore, takes 18 years for the “loan” to be fully paid back.  At that point, the lender would have effectively divested $250,000 tax free. The annual exclusion applies to the donor, not the recipient.  Accordingly, it’s also possible to pay off the loan twice as fast if a married couple makes that same $250,000 gift.  In that scenario, each spouse would contribute one half of the $250,000 gift the recipient. 

Lawyers for Tax Issues 

As you can see, the strategy outlined allows individuals to make large gifts and avoid the gift tax.  It combines them with an unsecured loan and a stream of small gifts below the filing threshold. Even though substantial sums of money may change hands, from a tax perspective, the funds have effectively disappeared. If you need lawyers for tax issues, it’s strategies like this that are invaluable.  That’s why it makes sense to contact Mackay, Caswell & Callahan. We’re familiar with a wide variety of tax strategies that can help you save money. If you have a tax issue call one of the top New York City tax attorneys today. 

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