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In working with the closely held family business, 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.
In essence, the business or wealthier, older generations loan funds to younger generations under preferable terms. These loans are at lower rates, lower or no down payments, longer repayment terms, absent of loan fees, and 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 borrowers 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 3 years, that rate is .31%. For a loan term of 3 - 9 years, the rate is 1.80%, and for loans longer than 9 years, the rate is 3.02%.
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.
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.
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