George F. Bearup, J.D. Senior Legal Trust Advisor

Intrafamily Loans and IRC 7872

Tale-Away: IRC 7872 provides that if an individual structures an intrafamily loan consistent with what that Tax Code requires, i.e. using the applicable federal rate (AFR) of interest for the month of the loan, that loan will not be treated as a gift for gift tax purposes. If IRC 7872 is followed, the promissory note that the lender receives will be deemed to be made for full and adequate consideration in money or money’s worth, and by implication, there is no gift. Unfortunately, the IRS has a different ‘take’ on intrafamily loans, even those that comply with IRC 7872, when valuation discounts are applied when the lender dies holding the promissory note.

Background: We have previously covered in some detail (some might say ‘way too much detail’) the benefit of an intrafamily loan to exploit the current low applicable federal rates of interest for August, 2020. If the loan proceeds produce a return greater than the interest rate charged on the promissory note, the difference results in a shift of wealth to the borrower without the imposition of any federal gift tax.

Lender’s Death: The question arises as to the fair market value of the promissory note when the lender dies, since the value of the promissory note must be included in the lender’s taxable estate. The lender’s estate will claim one value, while the IRS has been known to claim a different (no surprise, higher) value.

Example: Dan loans $10 million to a Trust that he has established for the benefit of his children and grandchildren this month when the AFR for long term transactions is 1.14%. The loan satisfies the IRC 7872 conditions as it uses the applicable federal rate (AFR) of interest for the month of the loan. Consequently, no gift occurs with Dan’s loan, and as a generalization, the promissory note that Dan receives is equal in value to the $10 million that Dan loaned to the Trust. The Trust timely pays Dan the interest on the promissory note, and if principal payments are due, those too are timely paid on the promissory note by the Trust. Dan dies a few years after the loan, having only received periodic interest payments. The $10 million promissory note is still in existence and outstanding at the time of Dan’s death.

Estate’s Position: The personal representative of Dan’s estate hires a qualified appraiser to value the promissory note who concluded “based upon all of the factors and the currently prevailing interest rates which are higher than when Dan made the loan to the trust, the value of Dan’s promissory note receivable can be discounted; the promissory note receivable’s fair market value at the date of Dan’s death is $7.0 million.” Dan loaned $10 million to the Trust. Dan expected to receive back the $10 million at the promissory note’s maturity upon full payment, but the promissory note receivable’s value that is used to calculate Dan’s federal estate tax liability is only $7.0 million. What happened to the other $3.0 million? The market changed over the years and a promissory note that pays a whopping 1.14% annual interest for several years is not an attractive asset to own.
IRS’ Position: The IRS, in its incessant search for tax revenues, takes the position that either IRC 2036(a)(2) or IRC 2038, two of the Tax Code’s string provisions, apply to the loan transaction, to cause the full $10 million face amount of the promissory note receivable to be included in Dan’s taxable estate. In effect, the IRS says: “We are going to include the unpaid face amount of the promissory note in Dan’s estate, even though the promissory note was deemed not to be a gift for gift tax purposes as full consideration was received by Dan, and therefore there was no retained interest held by Dan in the transaction. Rather, we are going to treat the promissory note as not being exchanged for full and valuable consideration, and therefore the string provisions under IRC 2036 and 2038 will apply.”
The Disconnect: Thus, IRC 7872 tells us that there was full and adequate consideration exchanged for the promissory note when the loan was made by Dan to the Trust. IRC 7872 provides that there was no gift because the appropriate AFR interest rate was used and no strings were retained by Dan in the transaction. However, the IRS is asserts just the opposite, that there was no fair and adequate consideration received at the time of the loan, despite the language of IRC 7872, in order to find an implied string, which then entitles the IRS to claim that either IRC 2036 or IRC 2038 applies to cause the face value of the promissory note to be included in Dan’s taxable estate.

Let’s Hope the IRS is Wrong: The IRS may be misguided in its search for tax revenues. Consider the following:

FLP Analogy: In a conventional family limited partnership (FLP) situation, the Father transfers $10 million of marketable securities to the FLP. He takes back only limited partnership interests. The Father’s capital account in the FLP is $10 million. Even though the limited partnership interests held by the Father are unmarketable and non-controlling, the Father’s partnership capital account is worth $10 million in the FLP and the Father is entitled to receive that amount if the FLP is later liquidated. If the Father dies owning only limited partnership interests which are valued at $7.0 million at the time of then Father’s death, because the limited partnership interests are neither marketable nor controlling, the Tax Court has regularly held that only $7.0 million is included in the Father’s taxable estate at death- the fair market value of Father’s limited partnership interests, not his FLP capital account. There should be no difference between the ‘missing’ $3.0 million in the FLP example or the fair market value of the promissory note that fully complied with IRC 7872- each transaction resulted in the lender/transferor initially receiving full consideration for the asset that he/she transferred, it is just that what he/she received in exchange is worth less after the passage of time and changing market circumstances.
Split-Dollar Analogy: This estate planning strategy was recently in the news in the 2018 Cahill Tax Court decision. Assume the Father, age 75, loans $10 million to a grantor Trust for the benefit of his descendants. The trustee take the $10 million of loan proceeds and uses them to pay the premium on a single premium life insurance policy that insures the life of the Father’s son, then age 45. The only asset in the grantor Trust is the life insurance policy. The Father’s loan to the Trust complies with the proposed Regulations under IRC 7872, as the loan used the AFR rate at the time of the loan to the Trust. Interest accrues on the Trust’s promissory note given to the Father. The promissory note matures when Son dies, probably 35 to 40 years later. The Father dies 5 years after the promissory note was given to him by the trustee. What is included in the Father’s taxable estate is not the $10 million plus accrued interest on the promissory note. Rather, $7.0 million is included in the Father’s taxable estate; the promissory note’s fair market value is heavily discounted at the time of the Father’s death since the promissory note will most likely not mature until his Son’s death, another 30 to 35 years into the future. There is not much present value in a promissory note the payoff of which is 30+ years down the road. IRC 7872 says this is a permissible outcome- the disappearance of $3.0 million in value between what was loaned and the fair market value of that promissory note received in exchange for the loan.

Two Asides:

(1) Income Taxes: In the split-dollar life insurance example, when the Father dies, the Trust will cease to be a grantor trust. The interest income on the promissory note will have to be reported since it is no longer a grantor Trust. Additionally, the interest expense cannot be deducted by the Trust because it is used to pay premiums on a life insurance policy. Consequently, the Father’s death creates an income tax problem both his survivors who hold the inherited promissory note, and also for the Trust since it cannot deduct the interest that it pays on the $10 million promissory note. So it is an interesting example, but it carries its own set of income tax traps.

(2) Proposed Regulations: The IRS’ proposed IRC 7872 Regulations, issued back in 1984 state, along with some later private letter rulings, that if a promissory note is issued in full compliance with IRC 7872 and its proposed Regulations at the time of its issuance, then the value of the promissory note will be presumed to equal the face amount of the note. Yet the IRS also in its proposed Regulations [proposed Regulation 7872-1] acknowledges the disconnect previously noted. It’s proposed Regulations state that it will not value promissory notes using later market rates or consider date-of-death circumstances. Rather, it will value a gift term loan at the present value of all payments using the ‘original’ AFR interest rate, in order to deal with the ‘disconnect.’ But here is the rub. A proposed Regulation is not binding on a taxpayer until it becomes final. The IRS has had from 1984 to 2020 to make its proposed Regulation final, but it continues only as a non-binding proposed interpretation of IRC 7872. In short, the IRS acknowledges that IRC 7872 creates a valuation problem for it when the holder of the promissory note dies, but it has yet to ‘fix’ that problem.

Planning with Low Interest Rates: As noted at the beginning of this missive, the currently low AFR rates can be exploited to shift wealth to family members at no gift-tax cost. A second estate planning benefit can be obtained with an intrafamily loan with the valuation of the unpaid promissory note at the time of the lender’s death. If the lender dies several years after the low interest rate loan to a family member, when the interest rates have risen, the face value of the unpaid loan will be discounted to reflect that loan’s fair market value as of the date of death. That lower fair market value can be further if a fraction of that promissory note is gifted by the lender prior to death.

Precedent: In a 1996 federal District Court decision Smith v. United States, the IRS challenged an estate tax return promissory note valuation that was based upon first the determination of the value of the promissory note itself based upon a discounted present value future cash flow calculation.(Discount #1.) The Court then applied a 20% valuation adjustment (Discount #2) because the decedent only owned 2/3 of the promissory note. The District Court judge found both discounts as being reasonable and appropriate.
Example: Following the earlier example, the Father loans to his Son $10.0 million using this month’s low interest rate. The promissory note calls only for the periodic payment of interest, with the note coming due in 20 years. The Father then transfers (assigns) one-third of the promissory note to a lifetime QTIP Trust established for the Father’s wife. The Father then dies. In the earlier example, the fair market date-of-death value of the face value $10 million note is $7.0 million. Following the Smith example, that $7.0 discounted fair market date-of-death value would be further discounted by 20%, or $1,400,000, to reflect that the Father only owned a two-third’s interest in the promissory note. In short, the $10 million loan is valued at $5.6 million at the time of the Father’s death.

Conclusion: The split-dollar Regulations under IRC 7872 provide that in valuing a split-dollar loan, general estate tax principles, along with current market interest rates and prevailing circumstances will be used to value a promissory note held by the decedent, thus entitling a decedent’s estate to claim valuation discounts for the promissory note. A promissory note that complies with IRC 7872 at its inception will be treated as a transaction for full and adequate consideration and not a gift. While the IRS may want to claim that the consideration received in exchange for the loan was inadequate to warrant the application of IRC 2036 and 2038, so far there is no legal basis for the IRS’s position. Thus, when the August 2020 AFR for long term loan transactions is only 1.14%, consider the size of the valuation that will be associated with that loan if the lender dies 15 or 20 years later holding a note that only pays interest at 1.14% per year. Consider further the second discount if a portion of that promissory note is transferred to a QTIP marital deduction trust created for the lender’s spouse.