Advances on inheritances are not as simple as you think

Parents and grandparents often “loan” or give more funds to one child than another.

Sometimes this is based on need — one child has trouble holding a job, or works hard at a lower paying job, while another maintains a successful career. Sometimes, it’s the nature of raising children who are different from each other: one child goes to an expensive private college and the parents foot the bill, while another child goes right to work after high school.

And sometimes it’s extenuating circumstances: One child has serious health setbacks, is the victim of a crime or goes through an expensive divorce, while another wins the lottery (for real or just in life). It happens.

But what if the parent wants to even things up with the child or grandchild’s inheritance?

There’s a right way and a wrong way to do that.

Grandma’s loan

Let’s say Grandma loaned Bobby $100,000 to start up a business. Then Grandma loaned Susie $20,000 to buy a car. There’s a third grandchild, Tiffany, who hasn’t needed a thing.

Grandma says, “I’d like the loans I made to be considered advances on the grandchildren’s eventual inheritance.” If Grandma has $600,000 in cash that is going to her grandchildren, how much does Bobby get? Susie? And perfect child, Tiffany?

Often, the heirs will think the math is easy: $600,000 divided by three grandchildren is $200,000 each. But Bobby already received $100,000, so his share is reduced by that amount, and he gets only $100,000.

Likewise, Susie’s $20,000 would reduce her share to $180,000. And Tiffany would get $200,000, right?

But what happens to the remaining $120,000? Does Tiffany get all that is left? That’s where the math falls apart, and we know it’s wrong.

If Bobby got $100,000 and Susie got $180,000, there is $320,000 left over for Tiffany! Finally, Tiffany’s payday comes in.

Sorry, Tiff, that’s not how it works.

How to account for advances

The correct math for loans treated as an advance on an inheritance is to treat the advances like accounts receivable.

Bobby and Susie’s loans of $100,000 and $20,000, respectively, are payable to Grandma’s estate or trust. As a result, the number that we’re working with, before we apply the offset, is not $600,000 but rather it’s $720,000 ($600,000 plus the $120,000 in “receivables”).

Think of it this way: If Grandma hadn’t loaned that money to the grandkids, there would be $720,000 to divvy up at her death. We’re restoring the account to that balance.

So that means the $720,000 divided by the three grandkids is $240,000 each. Bobby would get $240,000 less the advance of $100,000, for a total of $140,000. Susie would get $240,000 less the advance of $20,000 for a total of $220,000. Tiffany would get the $240,000 she always knew she deserved.

Bobby’s $140,000 plus Susie’s $220,000, plus Tiffany’s $240,000 equals the $600,000 in cash that Grandma’s estate had to dole out. This math works!

If it helps, consider that the money loaned to each child would have been one-third theirs anyway at Grandma’s death.

Other considerations

It’s important to have a carefully drafted trust to explain what is to be considered an advance on an inheritance and how it’s to be treated. (Side note: If you have enough assets to be loaning money, you need a trust, not just a will.)

In the above example, Bobby and Susie may still be better off than Tiffany, since they had money much sooner than Tiffany did. Grandma needs to be sure to state clearly whether interest is to accrue on the advance and, if so, at what rate? Or, should Tiffany get more cash to make up for the lost time value of money? Or is interest not to be considered at all?

And please, document the amount and existence of the loans or advances in writing. You cannot just say, “If I’ve made any loans to my children or grandchildren, such amount should be offset from their inheritance.” That flings open the door to arguments about who received how much as a loan.

There needs to be a specific method for determining what has been advanced to each beneficiary, whether that’s a listing attached to the trust, promissory notes, or specific advances (dollar amount and date made) listed in the trust.

It should not come as a surprise to the children or grandchildren that something they thought was an outright gift was, in fact, a loan or an advance on their inheritance.

Generosity is a virtue, according to Aristotle. Clarity is also a virtue, according to attorneys everywhere.

So, go ahead and make those advances, if you’re so inclined, but get them properly documented and save your heirs some disagreements or disappointments.

Teresa J. Rhyne is an attorney practicing in estate planning and trust administration in Riverside and Paso Robles, CA. She is also the #1 New York Times bestselling author of “The Dog Lived (and So Will I)” and “Poppy in The Wild.” Reach her at Teresa@trlawgroup.net