Orphans’ Court Litigation
March 16, 2015
The Trustee’s Power to Loan
Trust agreements often give trustees the power to make loans. When and how to exercise the power should be given significant thought. Upholding the fiduciary duty owed to all beneficiaries is always a key concern. Consideration of tax implications, due diligence and documentation are essential.
LOANS TO BENEFICIARIES
A loan taken from a trust can be good for the beneficiary or the beneficiary’s business and can be an alternative to making an outright distribution to the beneficiary. In determining whether to make a loan to a beneficiary, the trustee should consider the following:
The trustee should first determine whether the trust agreement (and not merely a trust certification) permits the trustee to loan money. If prohibited, the trustee may not make the loan.
If permitted, proper internal procedures, similar to those for making an outright distribution to a beneficiary, should be followed and documented.
Once it has been determined that the trustee has the authority to make a loan to a beneficiary, and subsequent to the trustee’s proper exercise of its discretion to make such loan, the collateral security requirements of the loan must be considered by the trustee. A beneficiary may benefit from relaxed collateral security requirements for the loan, as standard commercial lending criteria may be modified to suit the needs of the beneficiary. Nonetheless, the trustee should ensure that there is sufficient collateral for the loan, as the loan will be a trust asset and may be scrutinized for proper portfolio management by the beneficiaries or a court having jurisdiction over the trust.
The ability of the beneficiary to repay the loan must also be considered. If the trustee knows that the beneficiary will be unable to repay the loan, the loan could be challenged by the IRS and may be re-characterized as a disguised distribution to the beneficiary, which could cause an adverse income tax result for the beneficiary.
Although Congress has eliminated the tax advantages of interest-free loans, a trust loan with a below-market interest rate can be an attractive and viable financing option for a beneficiary. Provided the trustee complies with certain rules prescribed by the IRS pertaining to adequately stated interest, the trustee could decide to make a loan to a trust beneficiary in order to suit the needs of the beneficiary. For example, Rev.Rul. 2015-03 contains the minimum required interest rates for loans made in April 2015 and provides for (i) a short term rate for demand loans and loans with terms of up to 3 years equal to 0.48%; (ii) a mid-term rate for loans from 3 to 9 years equal to 1.70%; and (iii) a long-term rate for loans over 9 years equal to 2.47%. These rates are significantly lower than rates that would be commercially available to the beneficiary and, in general, may be used to the benefit of the beneficiary without an adverse income tax result.
Finally, all loans made to a trust beneficiary should be supported by appropriate documentation, such as a promissory note, and, if necessary, a collateral security agreement.
Repayment of a loan from a trust can be made from money the beneficiary might otherwise have been entitled to receive from the trust, or trustees can make loan payments on behalf of the beneficiary. The specific language of the trust and the powers expressly conferred upon the trustees determine these issues. Because of the significant fiduciary obligations associated with making a loan to a beneficiary, and because the IRS may carefully examine the loan transaction to determine the appropriate tax treatment to the trust and the beneficiary, the trust loan transaction should be carefully considered and documented by the trustee and its counsel. McNees attorneys have the fiduciary, tax and lending experience to help corporate fiduciaries navigate and document the complexities of trust loan.
LOANS TO TRUSTS
Sometimes the trustees of a trust may need or want to borrow money to preserve or make improvements to trust assets. Other times, trustees may determine that it is in the best interest of the trust beneficiaries to refinance property held in trust. In order to make sure such loans are permissible and are properly authorized, and the lending instruments are properly documented and executed, the trust agreement (and not just a trustee certification) should be reviewed by lender’s counsel. For example, the standard power of a trustee to borrow money alone is not sufficient to validly pledge or encumber trust assets. Additionally, the Truth in Lending Act and other consumer protection statutes may be applicable in some cases. Loans to trusts are generally not qualified for resale on the secondary market. McNees attorneys can guide you through all aspects of the process of lending to trusts.
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