Thursday, September 13, 2012

Beware the Pitfalls of Making Large Gifts or Loans to Your Kids

In counseling clients, I am always concerned when learning that parents have made, or are proposing to make, large monetary gifts or loans to their adult children.  The reasons for such gifts or loans vary.  Perhaps a child finds him or herself in financial difficulty, often as a result of a job loss, divorce, business failure, or dependency addiction.  Few parents, even those of limited means, turn away a child in need.

As the father of two children myself, I have nothing against such a parental "bailout" where a child is in genuine need. After all, family is family.  But frequently I see situations where an adult child convinces his or her parents into transferring to a child significant portion of the parents' life savings for non-essential needs, often for a questionable business venture.  In a perfect world, the child should first look to a bank for financing.  If a bank won't provide financing, that should be a red flag to the parent that they should think twice before providing the requested funds to a child, unless the parent is prepared to permanently part with the money.

For example, in one recent case my client had given her son $300,000 so that the son could purchase a sports bar.  The transaction was deemed a "loan," and the son gave to his mother a rudimentary promissory note.  However, the mother did not retain an attorney, so she did not have a mortgage placed upon the property,  leaving her loan unsecured.   In relatively short order the son's "can't miss" sports bar went bust, and mom's chances of getting the $300,000 back is uncertain at best.

In other cases, money may be given to a child in drips and drabs.  Typically the child in such cases has chronic financial problems, and even as an adult is largely dependent upon the parent for support.  Sometimes the child is just unlucky in life, but all too often I see cases where a parent enables a lazy or unmotivated child to live off of the parent's resources.

In cases where a parent is providing "help" to an only child, my main concerns are typically (i) to ensure that the parent retains sufficient resources to maintain their standard of  living, (ii) to understand the estate and gift tax implications of the transfers, and (iii) to understand the implications of such asset transfers on the parent's potential Medicaid eligibility should long-term care someday be necessary.  If those three issues are satisfactorily addressed, then a parent can make such transfers without significant concern.

But when there is more than one child in the picture, the situation takes a much different turn. In a situation where parents who have multiple children are financially assisting fewer than all the children, it is important that the clients understand the potential for significant strife among their children if the parents haven't made clear in their estate plan how such lifetime payments are to be treated after the parents' deaths.

Often the most equitable approach is to provide in the parents' will or living trust that the lifetime transfer to a child is to be deemed an "advance" on that child's inheritance.  That's what was done in the case mentioned above where mom gave her son $300,000 for his ill-fated sports bar.  Mom's estate plan provides that to the extent that the son hasn't repaid the loan, his share of the inheritance is to be offset by the unpaid amount.  For example, if mom's total estate is $1,000,000 at her death, the client's son and daughter would have otherwise been entitled to one-half of the assets, or $500,000 apiece.  But mom's plan provides that the $300,000 loan amount (or any remaining unpaid amount) is added to the total estate for determining each child's equitable share.  If the son's entire $300,000 loan remains unpaid at mom's death, then mom's total "estate" for distribution purposes is $1,300,000, with each child to be allocated from that sum the amount of $650,000.  Since the son has already received $300,000 of that amount, he would only receive $350,000 of the $1,000,000 from mom's estate, with his sister to receive the other $650,000.  Under this scenario, each sibling will have received substantially equal amounts of their mother's estate, including the large lifetime transfer to the son.  Such an equitable solution is far more likely to be palatable to the children, and is far more likely to result in harmonious sibling relations than in the case where large lifetime gifts and/or unpaid loans are not factored into the estate planning design.