All too often, intra-family loans are made quickly and informally, and are driven by emotion, without considering the effects on the family relationships or the next generation.
When clients ask accountants and tax advisors about how they should handle these loans, their advice usually centers on tax and financial matters. As vital as it is to structure and document the loan to meet Internal Revenue Service requirements, non-financial considerations are just as important. However, it is not routine for advisors to spend time explaining all of the ramifications that can result from making intra-family loans, or the options available to assist the next generation's own career, entrepreneurial, intellectual and financial development.
As a trusted advisor, you can play a high-value role for such families by helping them become aware that intra-family financing can trigger many unintended consequences, such as false expectations, family conflicts, misunderstandings, a sense of entitlement, and serious damage to family relationships if it is not handled carefully. These loans also represent an opportunity to empower the next generation to develop healthy family behaviors and relationships, life-long accountability, self-reliance, perseverance, and entrepreneurial spirit, as well as their personal wealth and interests.
ENTER THE FAMILY BANK
Rather than advising a family to make annual gifts in cash to each child or a "forgivable" loan, or to create a trust to provide annual unrestricted income, the senior generation may want to consider working with the next generation to explore ways that will not create a sense of entitlement or negatively affect emotions or motivations. Thoughtfully structured, intra-family financing can help develop responsible, life-long character and capabilities.
These families should be advised to take a more deliberate approach to wealth transfer by dedicating a small portion of their assets to a special entity that has been structured with the sole purpose of properly loaning money to or investing money in family members to buy a car or a college apartment, or to start a business venture.
This special entity -- known as a family bank -- would be a family-owned, family-funded company that finances only family members. For those families that have recently sold their family business, they can allocate a portion of their new investment portfolio directly toward promoting a family culture of hard work, entrepreneurship, and responsible management of money - all the things that may have created the family's original wealth in the first place.
Typically, senior family members (or even a family business or a family trust) can participate by providing the funds to the family bank company, which then finances the next generation's interests, business ventures, homes and other assets. The family bank can make loans to the individuals or directly to the next generation's controlled asset. Junior family members should be encouraged to invest some of their own capital to have some "skin in the game."
THE BENEFITS
A family bank may be preferable to outside sources of funding or more informal loans for many reasons. Banks and other external funding sources may not be as risk-tolerant or as patient with their capital. As long as the terms are compliant with IRS rules and the interest rate is at or above the Applicable Federal Rate, family banks have the flexibility to reward entrepreneurial risk and human capital development.
Family banks also are more likely to sidestep potentially unhealthy family dynamics that can occur with more informal loans, as long as they are treated like a professionalized family business, with proper documentation and a healthy governance system.
Family bank governance should include oversight and review by at least one non-family member to provide an objective viewpoint and to minimize the effect of family emotions on key decisions. Good family communications and family bank transparency are also important to keep family relationships healthy, maintaining trust and respect. Finally, by participating in the governance of the family bank, the next generation can prepare for eventual group decision-making and oversight of other family enterprises.
SPECIALIZED GUIDANCE
Unless the accountant or tax advisor understands family governance, next-generation development, and family banks as a holistic approach to intra-family financing, they should consider bringing in another advisor who really understands the family bank system benefits, limitations and options. The family bank advisor will work with the family accountant, attorney, tax and estate advisors to help the client carefully think through the purpose, scope, size, governance and structure of the family bank.
They can also help the family avoid potential pitfalls. For example, policies must be customized and flexible enough so that the bank will remain relevant to the next generation's needs and interests. However, without taking an appropriately professionalized approach, including objective oversight by non-family directors or a review committee, unhealthy family dynamics can take over. If loaning money to family members creates significant conflicts, a sense of unfairness, or a lack of trust, the family bank and family relationships will eventually be damaged or destroyed. Even a relatively small loan can cause resentment among family members.
Overall, it is important to keep in mind that family banks should be governed in a customized, democratized, flexible, harmonious and professionalized way, with an eye toward building financial and human capital and healthy family relationships. With attention to these key principles, family banks can be powerful entities that go well beyond tax efficiency to help future generations of a family become the kind of entrepreneurial and fiscally responsible people who can run a family business and handle the wealth it creates.
Warner King Babcock is chairman and CEO of AM Private Enterprises Inc., a registered investment adviser that provides strategic planning for wealthy families and families that own enterprises. Reach him at
