What Is a Crown Loan?
A crown loan is an interest-free loan without a maturity date. It is typically made by an adult in a high-income tax bracket to a person in a low or minimal tax bracket—like a minor child or another relative—to avoid or lessen the tax bite on the funds. In 1984, Congress and the U.S. Supreme Court closed the loopholes that made such loans attractive.
How a Crown Loan Works
Crown loans get their name from Henry Crown, a wealthy industrialist and renowned philanthropist from Chicago who first made use of demand loans as a way of transferring wealth to his children and grandchildren. Demand loans have no set maturity date, so their repayment becomes due only on the demand of the lender. Individuals using these loans typically did so to take advantage of the different tax rate their children or grandchildren would pay on the investment earnings of the borrowed money.
In today's tax law environment, the advantages of an interest-free Crown loan have vanished; in fact, the recipient could face taxes for receiving "forgiven debts."
The typical financial structure of such a deal involved lending funds to a child or grandchild. These funds would then be invested in an asset or financial instrument offering a high interest rate or rate of return. Because the borrower usually occupied a lower tax bracket than the lender, the amount of tax due on the investment gains would be much smaller. Since the funds represented a loan rather than a gift, the lender could avoid paying gift taxes on the amount of the loan, and the lender could avoid exposure to taxes on interest by demanding repayment of principal only.
Challenges to Crown Loans
The U.S. Internal Revenue Service (IRS) started eyeing Crown loans in the 1960s. In 1973, it sought to impose a gift tax on $18 million worth of such loans made to trusts established for children and other close relatives by none other than Lester Crown, one of Henry Crown’s sons. Lester Crown contested the tax in Tax Court and won: Although the IRS appealed, the U.S. Court of Appeals for the Seventh Circuit, in Crown v. Commissioner, upheld the Tax Court's decision.
However, a few years later, the IRS prevailed in another case. In 1984, in Dickman v. Commissioner, the Supreme Court upheld a ruling from the 11th Circuit assessing a gift tax on interest-free loans made by Paul and Esther Dickman to their children and a closely held family corporation. This ruling, along with additional legislation to close tax loopholes regarding loans with below-market interest rates in the Tax Reform Act of 1984, effectively removed the financial incentive to make Crown loans.
Current Tax Treatment of Crown Loans
Although they still exist, a high-wealth individual looking to benefit from Crown loans today likely would not find the practice advantageous, tax-wise. Under the terms of Internal Revenue Code Section 7872, the IRS generally can consider such loans (and demand loans in general) to be either below-market loans or gift loans, depending on the rate of interest charged and the nature of interest payments foregone by the lender.
Technically, this means that some or all of the loan—the principal, and/or the amount of interest it might have charged—is considered "forgiven," and debts forgiven by a creditor are taxable as cancellation of debt income. The bottom line, in practical terms: No-interest loans in general, and Crown loans in particular, become subject to tax.