Estate Planning / Business Planning / Improve The Odds
Intra-Family Loans
Copyright 1992, 2002 - Thomas J. Keating, IV, All Rights Reserved


"Neither a borrower, nor a lender be;
for loan oft loses both itself and friend,
and borrowing dulls the edge of husbandry."
W. Shakespeare, Hamlet (1601)

In many families, from the moderately affluent on up the scale, the subject of intra-family loans sooner or later arises. The purpose of this short essay is to discuss that subject, to talk about the credit process generally, to discuss the purposes (both good and bad) which can be served by such transactions, and to make some observations about the economic, tax and family dynamics issues which can arise in the context of this type of transaction.

Like just about everything else that families do together, intra-family loans can be enabling, constructive and mutually advantageous. They can also be evasive, selfish and otherwise damaging. The purpose of this essay is to try to alert you to some of the relevant issues and to make it easier for you to identify circumstances in which such a loan may be advisable or in which it may not.

The Purposes of the Loan. Let us begin with the purpose of the proposed loan. On the one hand, it could be a sound and constructive purpose, such as to finance (a) potentially useful and profitable educational attainment, (b) the commencement or expansion of a business which has reasonable prospects for success, or (c) the making of an attractive investment. On the other, it could also be an unsound purpose, such as (a) subsidizing indolence or indecision on the part of the borrower, (b) enabling lifestyle or consumer choices which cannot be supported by the borrower's own income or assets, or (c) permitting the repayment of already existing debt.

The touchstone of soundness, when thinking about the purpose and structure of a proposed loan, is whether or not it (a) constitutes a rational and productive use of capital, and (b) will assist, rather than impair, the borrower's ability to repay. No proposed loan transaction, whether presumed sound or otherwise, should even be considered unless the lender has the resolve to treat the transaction as a thoroughly arms-length arrangement, up to and including the willingness to enforce all possible legal claims against the defaulting borrower, if necessary.

One of the surest, even though often unconscious, ways for a lender to sabotage a loan transaction is to give the borrower any signal that if he (the borrower) gets in trouble the loan will be reduced or forgiven, or some other gratuitous accommodation will be extended. Wishful thinking being a nearly universal human failing, it would be a rare borrower in an intra-family loan situation who does not think he has some such signal, and, accordingly, the lender should go far out of his way to negate any such impression, and to impress upon the borrower the adverse consequences that will result if he doesn't repay the loan.

The Need for Formalities. An intra-family loan can be an extraordinarily powerful tool for illustrating the proper use and function of credit, but in order to do so, the lender must insist on observing all of the normal formalities and procedures. Failing to do so increases the risk of the transaction eventually going sour, and perhaps just as importantly, fails to educate the (usually younger and less experienced) borrower as to the proper significance and seriousness of the transaction. Almost invariably there will be, on one or both sides, a questioning of the need for such formalities and procedures, but that is wrong-headed in the extreme. Ignoring them trivializes the credit decision and sends an incorrect, and potentially harmful, message to the borrower. The message to the borrower in such a case is this --- the lender does not take this transaction seriously, so (the train of thought goes) why should I? Not a healthy mindset for a borrower to have, is it?

The Credit Decision. While banking institutions are not generally involved in intra-family loans, it may be useful for us to review together the guidelines which banks and other commercial lenders use in evaluating the soundness of a possible loan transaction. Bankers call these guidelines "the 5 C's of credit" and while they are necessarily quite subjective, they will nonetheless give you a clear idea of what should be considered by any prospective lender. Whole books, indeed whole libraries of books, have been written about this subject, but there is no need to replicate all of that here --- this will simply hit the high spots. The five C's are:
  1. The Character of the borrower. If the borrower's personal honesty and integrity are open to question, the loan should not be granted, no matter what a review of the other criteria might suggest. You just don't want to have a business relationship with a suspected cheat, the risk is simply too great.


  2. The Capacity of the borrower to repay. The lender should, on the facts available, be able to arrive at a judgment that the borrower will have sufficient funds to repay the loan, in accordance with its terms, at the time such repayment is expected. This gets into an analysis of the relationship between the borrower's level of income and level of expenditure, considering both the proposed loan as well as any existing, or other anticipated, obligations.


  3. The Conditions affecting the borrower's future ability to repay. This is chiefly an exercise in plausible prediction. What changes might take place which would affect the borrower's future ability to repay the loan? The central question here is "what could go wrong", and how bad an effect would that have on the likelihood of repayment? Are circumstances favorable for the activity that the borrower is planning to undertake with the loan proceeds? Can the borrower continue to meet all of his obligations if conditions turn out to be less favorable than anticipated?


  4. The Capital position of the borrower. Capital is the economic cushion that protects both the lender and the borrower if things do not work out the way they anticipate. Capital includes the ability to incur additional debt. In the event capacity is lacking, does the borrower have the ability to raise additional capital by borrowing against or liquidating unpledged assets?


  5. The Collateral security for repayment. This could consist of real estate (which would be made subject to a mortgage or deed of trust) or tangible or intangible personal property (which would be made subject to a security agreement). The questions to be asked with respect to all collateral that is to be pledged as security are (a) whether or not its value will be sufficient to offset the amount owed to the lender at the time of a possible future default, and (b) if a default occurs, how quickly and effectively could it be sold and the loan thus repaid?
A quick aside regarding this last question of collateral security. Our banker friends tell us, pious as priests, that "collateral is the least important ingredient in the credit decision". All of them say it; perhaps some of them actually mean it --- but you have only to see their body language when they become aware that collateral is (or is not) available to know that it is said for purposes of rectitude rather than reality. I do not dispute that, in an ideal world, this statement would be true; I can tell you categorically, however, that in the real world it is simply not. At his secret metabolic core, nothing makes the banker breathe easier than a nice solid chunk of collateral, preferably real estate, marketable securities or cash. The prospective borrower's ability to furnish such collateral will unlock a whole lot of doors that would otherwise remain firmly shut.

The Credit Analysis Problem. I am only too aware that credit analysis (which is the name given to the skilled review and consideration of the information on which a credit decision will be based) is an ability which not every lender in a possible intra-family loan situation may have developed. Accordingly, most of you will have to seek assistance from your lawyer, accountant and/or other professional advisors, but you should prepare yourself to take an active and inquisitive role in the decision process. The risk, after all, will be yours, and self-interest alone should persuade you to be deeply involved. The lender's main contribution to this process will likely be on a personal level, but that can be just as crucial as the financial analysis, if not more so.

A credit assessment by a family member, if it can be done in a completely objective and impartial manner (a big "if", I grant you), might actually be more accurate than one made by a commercial lender who has only a fairly superficial notion of the personal strengths and weaknesses of the proposed borrower. Some people who would look pretty unimpressive in a written resumé may have relevant strengths (e.g. perseverance, ingenuity, energy, focus, etc.) that do not translate well onto paper and, needless to say, someone with an impressive resumé can have relevant personal weaknesses also.

Each Loan Has Two Parts. Every loan transaction, except one which is for an almost instantaneously short term, has two separate and distinct parts or phases. The first phase, quite clearly and indisputably, consists of the credit decision itself --- do we make the loan or not, and if so on what terms and conditions? Perhaps not so clearly, but I believe equally indisputably, there is a second phase as well, and that is the administration of the loan by the lender. By administration I mean monitoring, throughout the duration of the loan, such things as (a) the application of the loan proceeds solely to the purpose(s) for which they were intended, (b) the condition of the collateral security, if any was given, (c) the incurring of any additional debt by the borrower and the use of the proceeds, (d) financial transactions between the borrower and related parties, (e) the borrower's status regarding taxing authorities and other creditors, and (f) the borrower's compliance with laws and regulations and/or any involvement in litigation. The lender must be firmly and resolutely prepared to call undesirable findings to the borrower's attention and to insist on corrective action. The lender should generally decline to offer further assistance if, owing to a lack of corrective effort, the conditions affecting the borrower continue to be less favorable than they were at the inception of the loan.

These administrative aspects are widely, perhaps almost universally, disregarded in intra-family loans, except among the most financially sophisticated people. Common sense suggests, however, that close attention to this second phase of the loan process can often be of great help in retrieving a loan which is becoming less secure, and should be viewed as an essential precaution in every significant intra-family loan transaction. I acknowledge that the typical intra-family borrower and lender might feel that this is unnecessarily intrusive, and for that reason I suggest that there be a formal loan agreement between the parties prior to the inception of the loan, which would specify the lender's right to receive current information and to monitor the borrower's activities. Commercial lenders do this routinely; there is no reason you should do otherwise.

When the Lender is Not a Person. Where the lender is not acting as a lender in his own right, but is acting instead as an official of a business entity or as a fiduciary, exceptional precautions and procedures apply. At a minimum, there should be extra caution taken in making the loan; extra diligence exerted in monitoring the loan, and extra restraint observed in agreeing to any forbearances requested by the borrower. In the case of a lender/business official, there should be full disclosure and meaningful consultation with the principal owners of the entity and, if possible, written approvals of the loan secured from each of them. In the case of a lender/fiduciary, the governing documents and the relevant law should be reviewed to confirm that such a loan would be legally permissible.

A Cultural Shift. There has been a significant cultural shift in the last half century or so which I believe has adversely affected the soundness of all types of loans, including even ones within a family. Fifty years and more ago, personal indebtedness was viewed as a matter of some disgrace, and, with the possible exception of a modest home mortgage, was avoided by almost everyone. Over the intervening years, however, there has been a substantial attitudinal shift, which, coupled with the rise of consumerism and the burgeoning availability of "consumer credit", has essentially removed the stigma from personal debt. Something else has also happened, which is that failure to meet one's financial obligations is itself no longer stigmatized as before, and, accordingly, the degree of moral suasion which used to provide a cultural buttress to the lender's position has largely disappeared. Even bankruptcy, that most draconian of bad outcomes, no longer carries even a tiny fraction of the social disgrace which used to be occasioned by it. The additional risk resulting from these changes in social norms cannot be quantified, but it is nonetheless real and should not be ignored.

I had thought, at first, to say that there is nothing much you can do about this and that I was just mentioning it in the interest of historical perspective. On reflection, however, I believe there is one thing that can be done, and that is for the parties to realize, particularly if they are a generation or more apart, that they may have, simply as a matter of cultural contrariety, somewhat different views regarding the sanctity of promises made and obligations undertaken. If such differences do exist, additional effort and discussion may be called for, focused on bridging this gap.

About Guaranteeing Loans. Now a word or two about loan guarantees. Perhaps at the risk of stating the obvious, a loan guarantee is an arrangement between a lender and a person other than the borrower (called a guarantor), to the effect that if the borrower does not repay the loan the guarantor will do so for him. Upon analysis, it will easily be seen that they are just as much a loan transaction as any other debtor/creditor relation, except that the other guy in the deal (the lender) gets all of the interest generated by the loan, and the guarantor gets nothing but the headaches if the loan goes sour. If intra-family loans are a suspect idea, loan guarantees by family members are doubly so. All of the same risks for the guarantor and none of the rewards. While the loan remains sound the lender gets the interest; when it goes into default the lender seeks repayment from the (invariably solvent) guarantor. Even worse than the standard borrower/guarantor arrangement is one in which the guarantor actually signs as a "co-maker" of the loan. The co-maker/guarantor's defenses against the lender are substantially reduced, and it is thus not surprising that, particularly with unsophisticated loan applicants, the lender will insist on a co-maker arrangement rather than a borrower/guarantor relationship.

Some Personality Questions. Neither every person nor every family situation is well suited to the carrying out of a successful intra-family loan. At the human level, there are certain personal qualities or characteristics which, if present, bode ill for success in such a venture. If either of the parties is not completely candid, or is a dreamer, a chronic idealist, or naïve and un-businesslike, problems are surely on the horizon. Let's look at a few specific personality questions and you will see better what I mean by this.

First, lender, consider the type of person who will become your borrower. If he is a chronic complainer or excuse-maker, he is apt to regard the loan arrangement as simply a platform from which he can subsequently try to extract a better deal than he originally made. If he is the sort who believes the world owes him a living, he will be full of complaints about how unfair it is that he should have to borrow the money (the unspoken additional thought being that he deserves the money as a gift). Finally, if he is the sea lawyer type (argumentative, cunning, a foot-dragger, etc.) he can actually be dangerous to have a business transaction with.

The borrower, for his part, would do well to be cautious of certain types of lenders also. If the lender is financially unsophisticated, he may enter into an arrangement which (a) is inherently riskier than he understands, or (b) exposes him to personal or family pressures which he will find unwelcome, and later complain bitterly that he was duped. If the lender is a chronic dependent (whether by circumstances or by choice), particularly one who is also manipulative or selfish, he may use the loan transaction as leverage to secure other collateral benefits or services from the borrower (cut my grass, take me to the store, fix my furnace, etc.). A borrower who has one of these types to contend with will wish he had gone to the Bank instead.

Economic Considerations. Throughout my thinking on this subject, I have been trying to identify those economic considerations which favor the making of intra-family loans. That effort, although sincere, has been largely unproductive. Virtually the only positive factor I have been able to identify is that the intra-family loan keeps the interest paid by the borrower "in the family", instead of letting it be paid out to strangers. Superficially this may seem quite a good thing, but one has to ask whether, standing alone as it seems to do, it adequately justifies such loans. The lender's capital is placed at risk, most likely a greater risk than a commercial lender would feel comfortable with, and the promised income stream, even if fully realized, is then eroded by taxes, and what is left after taxes is what is supposed to compensate the lender for taking the risk. Unless there is some issue I have not spotted, the intra-family loan would seem to fail the economics test, at least most of the time.

Tax Considerations. Some good many years ago, our government got the notion that the sly beast known as the American taxpayer was using intra-family loans to deprive the government of its proper revenues, and moved firmly to correct the situation. The objectionable technique went something like this.

Fat Cat father, very well-to-do and at the peak of his earning years, had a million or so dollars sitting around that he was doing nothing with at the moment. He also had a son, just out of college and with no immediate employment prospects, who was in a very low income tax bracket. The strategy (as viewed by the government) was that (a) father would lend the million dollars to son, either interest free or at a very low rate, (b) son would invest the same (probably with father's guidance, if not control) and, (c) the income from such investment would be taxable in the son's low-bracket rather than the father's high-bracket return. Given the substantial spread between the bottom and the top marginal tax rates, this could not only achieve some useful inter-generational shifting of spending power, at no gift tax cost (remember, the million dollars was a loan, not a gift), but it would result in a present income tax benefit to the family as a whole.

As these things typically go, the technique got some attention in the tax and business press, and the government figured they had better put a stop to it. The result is that now, as a result of a combination of laws, no-interest or low-interest loans can give rise both to gift tax and income tax problems for the participants. I am deliberately not going to describe this problem in detail, both because of its complexity and because of its changeability. Believe it or not, the standard of what constitutes an objectionable interest rate changes every month. Needless to say, even though the law is now very complex and quite restrictive, skilled tax practitioners can still achieve some useful results, but it would seem that the hey-day of this technique is past. One other tax aspect needs mentioning here: foregone interest or forgiveness of principal indebtedness may be subject to gift tax. This needs to be borne in mind if and when an intra-family loan is renegotiated or modified after being put in place.

Alternatives to Intra-Family Loans. On the supposition that most intra-family loans are resorted to because the borrower does not have access to conventional sources of credit (e.g. a local bank) it might be useful for me to mention some other possible alternatives. The most obvious, probably, is the United States Small Business Administration (SBA), which can serve as a guarantor or partial guarantor of credit extended by commercial lenders, and thus open doors for a disadvantaged borrower which would otherwise remain shut. Also, under some circumstances, SBA will make direct loans, but usually only to borrowers who have been persistently turned down by conventional sources of credit. In addition, most states in the United States have state level programs which have much the same function and purpose as SBA, and sometimes this type of activity is carried on also at the regional, county and/or municipal level. In addition, there are in some areas various government/industry partnerships which exist for the purpose of making loans to "start-up" businesses, often in specially targeted geographic areas, principally with a view to job creation. Most of this activity is state or locality specific, so any attempt at greater detail here would be inappropriate. Suffice it to say that an intelligent, energetic and focused inquiry may well bring to light a number of possible sources of credit which might make an intra-family loan unnecessary. Be prepared to put up with a whole lot of "red tape", however.

Quasi Intra-Family Loans. While most loans made outside the commercial context are between members of the same family (persons related by ties of blood and/or marriage), there are a good many such loans also made between persons who are not so related but who have other significant social and/or emotional ties to one another, and for whom the loan transaction is not, for these reasons, "strictly business". The same concerns and cautions which are discussed here regarding loans between family members are also germane to these other types of loans, and perhaps more so, in that the emotional and/or social ties that provided, at least in part, the impetus to enter into the transaction, can later be ruptured for reasons having nothing to do with the loan, and the successful outcome of the loan transaction placed in even greater jeopardy. If you want to get a good thumbnail sketch of the mistakes people make in this connection, spend an idle afternoon watching Judge Judy or one of the other "court TV" programs and you will get an appreciation of the ways in which people can mess up. Don't just smugly feel that the errors illustrated by these programs are only made by people who fail to document a $1,500 automobile loan; people make the same mistakes with regard to transactions involving vastly greater amounts as well.

Independent Representation. In all but the most trivial transactions, it is highly desirable, arguably even essential, for borrower and lender to be separately and independently represented by legal, accounting and financial advisors in connection with the negotiation, documentation and administration of the loan transaction. There are just too many points of conflict or potential conflict for any joint advisor to be safely (or ethically) able to straddle the entire situation. I realize that this advice is going to be widely ignored, but must persist in warning against what I know to be true of these situations --- that when the loan gets in trouble and fingers start to be pointed, the hapless joint advisor is going to feel pretty uncomfortable. In my view, both he and the parties will deserve their discomfiture.

Remediation. What if, despite all of the precautions, the loan transaction goes irretrievably sour? What possibilities of remediation exist? The answer is that, in many cases, no remediation is feasible, particularly if the borrower obtains bankruptcy protection and thereby prevents enforcement of the lender's claim. This is a time, needless to say, when any loan guarantees which may have been made are exploited, and efforts taken to induce the borrower to perform a constructive "work out" of its difficulties.

There is one situation in which there may be an effective remedial device. That is where the lender is the parent of the borrower and will have at the time of his death a substantial enough net worth to be able, by his Will, to adjust the distribution of his estate to take account of the failed loan transaction. The device employed for this purpose is generally known as an "estate equalization provision". Although it imposes substantial administrative burdens on the lender's personal representative, it can be an effective method of adjusting the estate distribution to take account of the involuntary "lifetime inheritance". The nuts and bolts of that type of arrangement are beyond the scope of this brief essay; suffice it to say that the tool does exist and might be useful in a particular case.

What This Essay is Not About. As should probably be obvious from the aforegoing discussion, this essay has no application to the types of intra-family loans which (a) are made with the proverbial "nod and a wink", and which are never expected or intended by either party to be repaid, and/or (b) are structured so as to facilitate the debt being incrementally forgiven over a period of time in the course of carrying out the lender's gift program. These are not actually loans, you see, no matter that the documents involved would suggest otherwise; the mutual expectation of the parties is that no repayment will ever be made, which makes them a form of gift. Wouldn't life be simpler all the way around if people would just call a spade a spade and have done with it?

In Conclusion. While much of this essay has a pessimistic (or at least cautionary) tone, there are clearly some circumstances in which intra-family loans can serve a useful and desirable purpose. What I hope to have persuaded you by this time is that, like everything else in life, it deserves some study, some planning, and perhaps a greater degree of knowledge and insight than you had when you began reading this. The stresses and strains which such a loan may produce can either be viewed positively, as a learning experience, or negatively, as an unwelcome burden. Like much else in life, effective communication holds a major key to the outcome, both at the human level and in terms of economic consequences. Candor is essential, but it is an unfortunate fact that sometimes candor is more difficult to achieve between family members than it is between comparative strangers.


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