What is a Trust Loan? A Complete Guide

Trust loans allow trustees and beneficiaries to access funds from a trust while keeping assets protected. They can provide flexibility and meet needs when distributions are limited. Though useful trust loans require care to implement properly. This guide covers everything you need to know.

What is a Trust Loan?

A trust loan is money borrowed from an irrevocable trust, usually by a trustee or beneficiary. It functions similar to a conventional loan, with repayment expected over time. Trust loans allow access to trust assets without depleting the trust corpus through distributions.

Trust loans are formal debt agreements made by the trust’s trustee per the trust terms The borrower signs a promissory note detailing repayment terms Interest rates on trust loans must meet IRS requirements. If rates are too low, tax issues can arise.

Common trust loan uses include:

• Beneficiary needs like education, downpayments, or medical expenses
• Trust administration costs
• Funding a buyout when dividing trust assets
• Taking advantage of tax rules like Prop 58

Trust loans balance beneficiaries’ needs today with preserving assets for the future. They provide access to funds when distributions are limited, like with spendthrift provisions. Loans also keep assets titled in the trust’s name for ongoing protection.

Key Benefits of Trust Loans

Access funds without distributions – Distributions permanently remove assets from the trust. Loans allow access without depleting principal.

Maintain trust protections – Assets remain titled to the trust so protections from creditors, lawsuits, etc. stay intact.

Flexibility – Can provide funds not permitted through trust distributions.

Lower interest rates – Minimum rates through trusts are lower than commercial loans.

Tax advantages – Interest paid to an irrevocable trust is not taxable income to the trust.

Facilitate wealth transfers – Loans between trusts can leverage tax savings.

When Trust Loans Make Sense

Trust loans serve needs distributions alone cannot. Common examples include:

• Urgent expenses – A loan can quickly provide funds the trust would distribute over time.

• Restricted distributions – Loans offer access despite tight limits on distributions.

• Spendthrift provisions – Loans provide funds when distributions are fully discretionary.

• Tax minimization – Removing assets can accelerate trust income taxes owed. Loans defer taxes.

• Buyout negotiations – Loans facilitate asset division among beneficiaries.

• Leveraging exemptions – Loans between trusts can maximize use of gift/estate tax exclusions.

Possible Downsides of Trust Loans

While useful, trust loans also come with risks, such as:

• Putting trust assets/repayment at risk
• Unclear terms leading to disputes
• Administrative complications
• Tax issues if structured improperly

Poorly implemented loans can also lead to conflict if some beneficiaries receive loans but not others. Ongoing advice from trust professionals helps mitigate risks.

Key Elements of Trust Loan Agreements

Formal loan documentation is critical. Key details to define in trust loan agreements include:

• Interest rate – Must meet or exceed IRS minimums based on AFR rates each month

• Payment terms – Payment amounts, due dates, balloons, etc.

• Maturity date – Date full repayment is expected

• Collateral – Asset securing the loan if applicable

• Default provisions – Steps the trust will take in case of nonpayment

Notes should be written and signed by the borrowing party. Other documents like mortgages may be needed to secure loans. Trust counsel can ensure proper documentation.

Interest Rate Requirements for Trust Loans

For intrafamily loans, the IRS establishes minimum interest rates, known as Applicable Federal Rates (AFR). Minimum AFR rates as of March 2024 are:

Trust loan rates must equal or exceed the AFR based on the loan term. Otherwise, the IRS can recharacterize a below-market loan as a gift, with tax consequences.

AFR rates fluctuate but are generally favorable vs. commercial loan rates. Trustees can charge higher rates at their discretion. Rates on loans to non-beneficiaries should be set appropriately as with any trust investment.

Trust Loan Payment Options

Repayment structures can provide additional flexibility. Possible options include:

• Interest-only – Payments cover interest charges only with balloon principal payment at maturity.

• Amortized – Principal & interest included in periodic payments.

• Deferred payments – Postpones payments entirely for a set period.

• Forgiveness – Principal/interest forgiven over time or at maturity. Requires coordination with distribution trustee.

• Rollover – Principal & interest due paid by taking out a new loan.

Trustees weigh options to accommodate beneficiaries’ financial situations. Loan forgiveness equates to distributions, so those decisions factor trustee duties to all beneficiaries.

Trust Loan Decision Authority

For directed trusts, determining who can authorize loans gets complicated. Common questions include:

• Is it an investment decision for the investment trustee?

• Is it a distribution decision for the distribution trustee?

• Does the trustee have authority if terms are favorable to a beneficiary?

Governing documents ideally outline loan authority explicitly. Ambiguity otherwise requires legal consultation to parse trust language and applicable statutes.

To avoid issues, trustees often take a conservative approach. Seeking both investment and distribution authorization assures proper oversight.

Should Trusts Make Loans or Distributions?

Trustees weigh the benefits of loans versus distributions carefully. Considerations include:

• Income tax consequences – Loans defer taxes on asset gains.

• Maintaining trust protections – Loans keep assets titled to the trust.

• Beneficiary financial skills – Loans expect repayment versus distributions.

• Administrative needs – Distributions are simpler to administer.

• Impartiality concerns – Loans should not overly favor some beneficiaries.

• Asset risks – Loans may put assets/repayment at risk.

• Trust purposes – Does a loan or distribution better align with the settlor’s goals?

Weighing the settlor’s intent and each beneficiary’s circumstances guides the decision. Trust counsel provides important perspective.

Alternatives to Trust Loans

Beyond distributions, other options exist besides loans for beneficiary needs:

• Trust purchases asset – Trust buys and retains ownership of home, business, etc. that beneficiaries utilize.

• Hybrid approach – Combination of upfront distribution and loan for remaining needs.

• Staggered distributions – Plan series of distributions over time instead of one lump sum.

• Third party financing – Beneficiary borrows from traditional lender with trust backing.

Each option has pros and cons for maintaining trust benefits and asset security. Creative solutions balance flexibility and trust protections.

Best Practices for Trust Loans

Careful implementation ensures trust loans meet their objectives:

• Review trust terms closely – governing document determines ability to make loans.

• Consult trustees, advisors – ensure consensus on authority to loan and purposes.

• Document formally – notes, security interests should evidence transaction.

• Follow trust processes – get required approvals from investment/distribution trustees.

• Set AFR+ interest rates – adhere to IRS rules to avoid reclassification as gifts.

• Keep other beneficiaries informed – transparency avoids perceptions of bias.

• Outline risks for borrowers – ensure understanding of obligations and implications.

With proper care around trust processes and documentation, loans can provide valuable flexibility trustees need.

Trust loans allow trustees and beneficiaries to responsibly access funds from irrevocable trusts. Though more complex than distributions, loans can provide needed liquidity not otherwise available. Following best practices around trust terms, documentation, and tax compliance helps ensure successful outcomes. With proper implementation, trust loans deliver significant benefits for trustees and beneficiaries alike.