TL;DR If you need to exercise your options, buy a house, invest, pay off debt, or make another large purchase, a loan from a family member known as an intrafamily loan can be an effective way to achieve liquidity. They're not considered gifts since the receiver of the loan has to pay interest (at least equal to the applicable federal rate). However, since these rates are lower than what a bank would usually offer and family members are more likely to lend a higher amount, intrafamily loans can still be very attractive. You’ll want to carefully consider the tax implications and your own family dynamics before pursuing this option.
What is an intrafamily loan and when would I use one?
You just joined a startup and you are considering early exercising your stock options, or maybe you’re a founder who wants to buy a house or bootstrap your own business, but you don’t have enough liquidity. As a startup employee or founder, borrowing from a traditional lender may be challenging or expensive due to the lack of liquid assets you have available to borrow against. There’s another option that might make sense for you: an intrafamily loan.
If your family members do not have a lot of liquidity to lend out (i.e. most Americans), this piece may not apply to you today. We thought it made sense to share it though, so you could have an idea of how the intrafamily loan system works.
Under rules set forth by the IRS, it is possible to make loans to family members at lower rates than those charged by commercial lenders without it being deemed a gift. The lender, usually a parent or grandparent, must charge interest in order to avoid making a gift to the borrower. The interest rate of the loan must be at least equal to the applicable federal rate. This makes intrafamily loans an especially attractive option in a low interest rate environment like today.
You can find the current applicable federal rates here at IRS.gov. The length of the loan should correspond to the AFRs: short-term (three years or less), mid-term (up to nine years), and long-term (more than nine years).
It is extremely important to ensure that the interest rate of an intrafamily loan is equal to or greater than the applicable federal rate. Otherwise, it will be considered a gift. Gifts of up to $16k in 2022 are excluded from counting against a person’s lifetime ability to give gifts ($12.06M in 2022) without triggering taxes for the receiver. Otherwise, the giver would have to file a gift tax return with the IRS for anything above $16k, or $32k if it is a gift from two spouses.
What are the benefits of an intrafamily loan?
An intrafamily loan offers several advantages. For one, you can take advantage of the above section and secure a low interest rate at the current federal rate. In theory, you could also borrow a larger amount from your family member than from a bank since there’s no limit to how much they can loan.
When properly structured, an intrafamily loan can also be an effective wealth transfer planning tool. Any gains from investing the borrowed money would not use any of your lifetime gifting exclusion. For example:
- Parent lends child $1M at 0.17% interest for 1 year (current AFR for a short-term, compound loan)
- Child invests the $1M and earns 10% or $100k total return
- At end of year, child repays $1M loan + $1.7k interest (0.17%). Child gets to keep the $90k after paying the $10k interest.
- Because this was a bonafide loan from parent to child, no gift tax occurs, though the child may need to pay individual income or capital gains taxes on the $100K earned from investing depending on how they used the money.
What are the tax implications I should know?
There are several tax considerations for intrafamily loans. For instance, the interest on the loan is taxable as income to the lender. When a lender forgives interest on a promissory note (a written promise by one party to pay another party a definite sum of money), that lender must still recognize the forgone interest as income. The family member/lender can forgive the interest on a loan using the annual gift exclusion each year. For example:
- Parent lends child $1M at 0.17% interest, ($1.7k)
- Parent can consider that $1.7k a gift
Depending on the use of the loan, interest expenses may be deductible. Ask your CPA ahead of structuring the loan to ensure you plan in a tax-optimized way.
How do I set up an intrafamily loan?
Make sure to document your intrafamily loan, especially if it’s a larger loan. The important items to document are the parties involved, the length of the loan (which helps determine the applicable federal rate), interest rate, and timing of payments. You can even find a fill-in-the-blank template from eForms or LegalZoom.
Items you might include in your intrafamily loan agreement include:
- Name of the lender and borrower
- Loan amount
- Whether the loan is secured or unsecured
- If it’s secured by collateral: What is the collateral? When can the lender take possession of the collateral (for example, after three months of missed payments? One year?)
- Interest rate
- Payment amount and frequency
- Payment due date
- Whether the loan has a co-signer, and if so, who?
It’s possible to structure the interest as accruing and payable at the end of the loan if you expect to have limited liquidity over the life of the loan.
DISCLAIMER: This is not legal advice and any agreement should ideally be finalized by an attorney for many reasons, among which is the fact that there are state-specific nuances and requirements.
What are the tradeoffs if my family member just wants to give me the money?
Maybe your parent doesn’t really mind if you can’t repay the loan. In some cases, it may be easier to just gift the money rather than to pursue an intrafamily loan depending on your family’s particular financial situation and dynamics. It really is a question of whether the giver wants the money back. To decide whether a gift or an intrafamily loan makes more sense for you, have an honest conversation with your family about your respective priorities and the true expectations regarding repayment.
For founders and early startup employees with a lack of liquid assets to borrow against, getting a loan from a traditional bank can be out of reach. Intrafamily loans propose one way to “hack” liquidity so you can have the cash on hand to early exercise, buy a house, invest, or help with any other large purchases. Keep in mind that this strategy is most appropriate for families with significant cash or liquid assets. Parents and grandparents should not risk their own future financial security using this strategy to help children or grandchildren build wealth. Whether an intrafamily loan is an effective strategy for you will depend on your family’s financial circumstances and long-term goals. Consult with your financial professional or CPA if you are considering an intrafamily loan.