Making a family loan? Watch out for the tax issues

At a time of higher interest rates, making loans within a family can be a useful alternative to borrowing from a bank or other commercial lender to help start a business or buy a home. While private loans can be cheaper, are more convenient and flexible than formal arrangements, it is important to carefully consider the taxation implications of making such a loan.

Practical loan considerations and arrangements

Firstly, consider whether you can afford to make the loan and whether if your circumstances where to unexpectedly change would you be left with enough liquidity? How would you stand if the borrower cannot or will not repay, is hoping not to have to repay the money the loan or is looking for a gift? In the interests of maintaining a good family relationship, it is better to discuss repayment terms beforehand - you might then decide it is preferable to offer to make a gift, albeit of a lower amount.

You do not have to charge interest for the loan and many family loans are made interest-free. If you do charge interest, the interest payments received by you will be taxable income in your hands and must be declared to HMRC. For families with cash surpluses, making interest bearing loans can provide a better return than leaving cash in a bank deposit account. Charging interest, even at a discounted rate, may also discourage the borrower viewing the loan as a gift and encourage them to repay the loan as soon as they are able.

In some circumstances, the borrower may qualify for tax relief on the interest payments if they apply the loan for a ‘qualifying purpose’ which can include:

• Buying shares in, or making loans to, a close company
• Making a loan to a partnership in which they are a partner
• Purchasing a ‘buy-to-let’ property (in recent years this relief is now restricted to the basic rate of tax for residential properties).

It is not compulsory to draw up a loan agreement, but it is a good idea to do so. Setting out the loan conditions in writing gives you the opportunity to make it clear to the borrower what your terms and conditions are for making the loan including when the loan is to be repaid. This helps avoid misunderstandings and may be used to support the existence of the loan for tax purposes if necessary.

Some circumstances may warrant the costs of engaging a lawyer to draft and execute a formal legal document between both parties under which the lender could (as a last resort) sue the borrower if they default on the loan repayment. It is also important to get specific legal advice if the loan is to be secured by a charge over a property or other asset. For example, you may want to build in some protection to ensure the funds are kept within the family if the borrower separates from their partner.

Inheritance tax

Inheritance tax (IHT) is a key consideration when loaning money within the family. From an IHT perspective, it is preferable to make a loan repayable on demand so that the value of the lender’s estate remains the same. This prevents the loan being treated as a ‘transfer of value’ which may be subject to IHT.

The amount of the outstanding loan remains in the lender’s estate for IHT purposes. For example, an individual may have made a loan many years ago of say £100,000 which has not been repaid. This £100,000 will remain part of the lender’s IHT estate. It should be noted that the value does remain fixed at the value of the original loan and any growth in value obtained by the borrower is outside of the lender’s estate.

If the debt is waived, it then becomes a gift. At this date (and not when the loan was made) the gift is treated as a potentially exempt transfer which will fall out of the lender’s estate seven years later. For example, say the £100,000 loan was made in 2010 and ultimately waived on 1 February 2020. This will be a £100,000 gift made on 1 February 2020 which becomes a potentially exempt transfer for the period to 1 February 2027 (after which it ceases to be considered for IHT purposes).

If the borrower dies with the loan outstanding this will be a deductible liability for calculating the value of their net IHT estate providing it is not caught by the restrictions on deducting liabilities for IHT purposes which were introduced in July 2013.

These restrictions apply to liabilities used to finance excluded property or UK foreign currency bank accounts left out of account and property subject to business relief, agricultural relief or woodlands relief. In addition, the liability must be discharged from the estate on death unless it can be shown there is a ‘real commercial reason’ for the liability not being repaid and securing a tax advantage is not the main purpose, or one of the main purposes, of leaving the liability outstanding. 

Trusts

Family trusts may also lend money to their beneficiaries, if the trustees have the necessary powers in the trust deed. Modern trust deeds will usually give the trustees a wide range of powers including the ability to make interest free loans. The trustees must consider whether a loan is the most appropriate way to help a beneficiary and how this might affect the interests of other beneficiaries, particularly if one of the capital assets of the trust were to turn into an irrecoverable loan.

Capital value leaving the trust has IHT implications and, dependent on the IHT regime applicable to the trust, may trigger an immediate IHT liability. The value of a loan does not leave the trust as the debt receivable remains an asset of the trust. However, to avoid the suggestion that value has left the trust, the trustees should make the loan repayable on demand and properly document the decision to make the loan by way of a loan agreement with the beneficiary so that it is clear the amount they have received is a loan and not an outright advance of capital.

If the trustees waive the loan, the value released would become a capital appointment and the IHT implications of this would need to be addressed.