In working with the closely held family businesses, I have found the Family Bank to be an excellent tool when properly used. In his book Family Wealth, James E. Hughes says, “The Family Bank provides a means for a family’s wealth to be leveraged by making loans available to family members on terms not available commercially.” The Family Bank allows families to pass along substantial wealth through several generations, without encountering wealth transfer taxes.
How does the Family Bank work?
In essence, the business or wealthier, older generations loan funds to younger generations under preferable terms. These loans are at lower rates, have lower or no down payments, have longer repayment terms, are absent of loan fees, and contain fewer covenants and restrictions.
Loans can be personal in nature—for instance purchasing a home:
It is important to recognize this as an “enhancement loan” not a “reliance loan.” What I mean by this, is that any savings due to a rate that is lower than the market rate, or by the borrower not having to pay mortgage insurance, should be used to “enhance” the borrower’s financial situation. This can be done by allowing repayment of the loan over a 15- or 20-year period, rather than maintaining the same 30-year loan amortization. The latter may cause a “reliance” mentality: where the family member becomes increasingly reliant on the family wealth, rather than progressively less reliant over the course of time.
The IRS comes into play with related party loans and requires the interest rate to meet a standard called the “Applicable Federal Rate,” or AFR. During the month of July 2014, for a loan less than three years, that rate is 0.31%. For a loan term of three to nine years, the rate is 1.80%, and for loans longer than nine years, the rate is 3.02%. (Monthly Compounding. Rev-Rul 2014-20)
Loans can be for business opportunities—such as start-ups or acquisitions:
In the case of business opportunities, the borrower should prepare a business plan, discuss feasibility with the family leadership team, possibly provide security for the loan, document the understanding and terms, and eventually repay the loan.
What should the design of “Family Bank Loans” look like?
- Available to all who meet specific qualifications
- Promote financial stewardship
- Possibly include guarantees by family members
- Encourage family unity rather than “favorites”
- Make financial sense
What are the practical aspects of designing the Family Bank Loan?
- Draft a proposal for all parties to review.
- Propose the amount of the loan and the key terms, amount to be borrowed, proposed interest rate, length of repayment, monthly payment amount (it takes us a few minutes to run an amortization schedule).
- Outline the security. For example, record a trust deed for a home purchase loan to allow the borrower to deduct the interest payments.
- Consider any potential landmines and address them up front.
Successful family businesses recognize that the family wealth is an asset to be well-managed. Additionally, opportunities to benefit the family members can also be excellent vehicles for passing on financial intelligence and stewardship.
Still curious to learn more about the Family Bank? Our team at Delap is happy to answer any questions regarding this tax concept, or any other accounting and finance challenges you may be facing. Reach out today!
Delap is one of Oregon’s largest local tax, audit, and consulting accounting firms, located in Lake Oswego.
Contributed by Dave DeLap