I. Overview of Promissory Notes

Promissory notes are commonly used within the Private Client Services practice at Wilchins Cosentino & Novins LLP, as financially established clients may want to help their adult children purchase a home or encourage entrepreneurial growth by lending money (as opposed to gifting money) at a rate much lower than commercial financial institutions. Parents, in turn, can enjoy income through the children’s repayments of interest on such loans (in addition to eventual repayment of the principal originally loaned). The promissory note approach allows clients to safely invest in the next generation as part of a comprehensive financial growth strategy.

To ensure compliance with federal tax regulations, particularly those regarding income, estate and gift tax, families should carefully adhere to the requirements of promissory notes and be cognizant of IRS triggers, as summarized below.

II. IRS Concerns Regarding Intrafamily Transfers

The IRS scrutinizes loans made between family members due to concerns that such loans are not bona fide loans, but rather disguised gifts that should be subject to gift tax. Therefore, the promissory note (the “Note”) must charge a rate equal to or greater than the Applicable Federal Rate (“AFR”) at the time the Note is executed.

Using a Note in which the parent or family irrevocable trust is the “Holder” of a promise made by the child (the “Maker”) to repay a loan allows the Holder to set terms for repayment of the Note, such as equal amortized payments over the lifetime of the loan or interest-only payments for a specified period with a balloon payment at the end. The Holder can choose to forgive principal and/or interest payments on the Note over time, allowing the taxpayer flexibility as a “friendly lender” in the event the Maker has financial difficulty. The Holder should consider how these forgiven payments will be reconciled in light of the annual gift tax exclusion amount ($19,000 per individual donor to individual donee in 2025). Gifts in excess of the annual exclusion amount will likely need to be reported on a gift tax return.

The IRS, operating under the presumption that such transfers are gifts, will consider several factors¹ in determining whether the lender truly intended the transfer to operate as a “bona fide” loan for which he or she would seek repayment.

Terms

• Was interest charged?²
• Was the note secured (i.e., was collateral provided)?
• Was a fixed date set for repayment of the note?

Documentation

• Was the note signed by the borrower?
• Do the records indicate that the transfer was, in fact, a loan?
• Was the transaction reported as a loan for federal tax purposes?³

Context

• Was repayment demanded?
• Was repayment made?
• Did the borrower have the financial ability to repay the note?

III. Conclusion

Intrafamily loans can be used to promote financial growth and independence, such as fostering a fledgling business or purchasing a first home, thanks to non-predatory interest rates and options to forego collateral.

To avoid tax complications and ensure that the loan will be repaid, it is crucial to set clear terms under a properly executed promissory note, thoroughly document the loan and all transactions associated with the loan, and operate within the established parameters for private loans.

For a customized strategy carefully tailored to meet your family’s needs, contact the attorneys in our Private Client Services practice at WCN to assist you.

Mary G. Wilson is an attorney in WCN’s Private Client Services practice. Learn more about Mary.

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This article is not legal advice and should not be taken as such or relied upon as legal advice.

¹ For more information regarding the IRS considerations in examining promissory notes and other methods of intrafamily loans, see https://www.nolo.com/legal-encyclopedia/free-books/avoid-probate-book/chapter9-4.html.
² Interest rates for private loans that are below the Applicable Federal Rate (AFR), the interest rate set each month by the IRS for such loans, will be treated as gifts to the extent that such rates are below the AFR. https://www.irs.gov/applicable-federal-rates.
³ Interest collected on promissory notes is considered income to the lender and should be reported as such. https://www.irs.gov/taxtopics/tc431.