The Perils of Making Lifetime Gifts and Loans to Your Children

When counseling clients, I am always concerned when I learn 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 if they have limited means, turn away a child in need.

As the father of two children, I have nothing against such a parental bailout where a child is in genuine need. After all, family is family. However, I frequently see situations where an adult child convinces his or her parents into transferring a 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 will not provide financing, it should be a red flag to the parent to think twice before providing the requested funds, unless the parent is prepared to permanently part with the money.

In one recent case, my client had given her son $300,000 that the son applied to the purchase of a sports bar. The transaction was deemed a loan and the son gave 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 the mother’s chances of getting the $300,000 back is now uncertain, at best.

In other situations, 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 parents’ 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.

However, when there is more than one child in the picture, the situation takes a 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. This is what was done in the case mentioned above where the mother gave her son $300,000 for his ill-fated sports bar. This woman’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 the mother’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 each. Luckily, the mother’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 his mother’s death, then the 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 his mother’s estate and his sister would receive $650,000.

Under this scenario, each sibling will receive 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, rather than the case where large lifetime gifts and/or unpaid loans are not factored into the estate planning design.