Loan from By Pass Trust

A Spouse died and left $600k in a credit shelter trust. The trust was funded with stocks and bonds. The trustee loaned the investments to the surviving spouse to use as collateral for funding of a business loan. The surviving spouse is paying the trust the prevailing rate of interest on the funds loaned. On death it will be repaid.

Sounds OK economically, but there are potentially significant legal issues. A loan from a trust to a related party subject to issues of self dealing for the trustee (a loan to a related party is likely a violation of the trustee's fiduciary duty to the beneficiaries), prudent investor act (the trust owns now a single asset instead of a diversified investment portfolio), etc. The really significant risk seems to be a disgruntled heir that has it in for the trustee. Further if the trustee ever needs a court approval of an accounting to obtain a release it may not be easily forthcoming. While this may all sound far fetched, if there is an alienated child that is the remainder beneficiary, or if it’s a second (or later) spouse, with children from a prior marriage as remainder beneficiaries, I would recommend caution.

If you are asking from a tax perspective, not from a trustee liability perspective if you have signed notes between the right parties and pay at least the minimum federal interest rate under Code Section 1274, there should not be a tax problem.