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

25-Nov-20

Gift of a Legally Enforceable Promissory Note

Take-Away: For those individuals who wish to make a large lifetime gift in order to consume their temporary large federal gift tax exemption, but who are reluctant to actually give up control of the gifted assets, they might consider the gift of a legally enforceable promissory note.

Thanks: A special note of thanks goes to Traverse City estate planning attorney Terry Rogers for bringing this estate planning strategy to my attention!

Background: The current federal gift (and estate) tax applicable exemption amount is $11.58 million per individual. That tax exemption is schedule to return to somewhere around $5.0 million beginning in 2026. There is also the concern in some circles that the gift tax exemption amount might drop back to an even lower amount prior to 2026 if Congress decides to get serious about addressing the federal deficit. [President-elect Biden recently mentioned in his campaign the potential for a $1.0 million lifetime gift tax exemption amount per individual.] That has led many individuals to consider making a large lifetime gift that currently uses their temporary federal gift tax exemption amount, while it still exists. However, those same individuals are worried about retaining enough assets to live on, so they may be reluctant to make a large gift of their assets at this time in order to use their available federal gift tax exemption.

Gift of a Promissory Note: One potential solution that uses the temporary federal gift tax exemption while it still exists is to make a gift of  a legally enforceable promissory note. With this approach the individual retains his or her assets. The individual gifts a legally enforceable promissory note to the donee, which is a completed gift for federal gift tax reporting purposes. The gift of the promissory note uses the individual’s currently available federal gift tax exemption, so long as the promised gift is an enforceable contract under state law. However, it is a long and complex ‘road’ to glean the merits of the gift of a promissory note.

Revenue Ruling 84-25: This 36 year old Revenue Ruling provides  a ‘roadmap’ for donors to follow to understand the tax consequences of their gift of a legally enforceable promissory note.

  • IRC 2511: The Revenue Ruling sanctions a gratuitous transfer of a legally binding promissory note as a completed gift. [IRC 2511.] Thus, the donor’s gift tax exemption can be used to shelter that gift from federal gift taxation. The donor’s intent behind the gift is irrelevant. The gift tax Regulations provide: “the application of the gift tax is based on objective facts of the transfer and the circumstances in which it is made, rather than the subjective motives of the donor.” [Treas. Regulation, 25,2511-1(g)(1).] Consequently, an individual can make a transfer and have it treated as a taxable gift even if he or she has no actual donative intent, and even if there is a subjective intent to not honor the promise to pay cash or other property in the future. It is still a taxable gift if the promise to pay is legally enforceable. If the promise to transfer cash or property in the future is reported as a taxable gift on a Form 709 and the gift tax assessment period (3 years) lapses, the promise to pay will be treated as a lifetime taxable gift, even for federal estate tax purposes [more on that below.] The gift takes place when the promissory note is delivered and is subject to gift taxation in the year that the obligation is undertaken, not when discharging payments are made on the promissory note. Rosenthal, 44 AFTR 90, 205 F.2d 5050, 53-2 USTC No. 10843 (CA-7, 1952.)

The ‘roadmap’ gets a bit more complicated, though, when the donor-promisor dies while the gifted promissory note remains unpaid.

  • IRC 2053(c): This Tax Code section generally provides that outstanding debts of a decedent, e.g. the debts of the donor, are subtracted from the decedent’s taxable estate in the determination of the federal estate tax that is due on death. The donor-decedent still owns the property that was to be used to satisfy the promised gift. However, the Revenue Ruling provides that the donor-decedent’s estate is not entitled to a deduction for the outstanding debt obligation because the obligation, i.e. the unpaid promissory note,  was not the subject of a “bona fide contract” and thus it is not a deductible estate debt. [IRC 2053(c)(1)(A).] The gifted promissory note is not treated as a deductible debt of the decedent under IRC 2053 because it was not contracted for full and adequate consideration, it as a . As a result, the outstanding and unpaid promissory note will not reduce the size of the donor-decedent’s taxable estate.
  • IRC 2001(b): The way the federal estate and gift tax rules work together, the federal estate tax is determined by calculating the tentative tax that is on the combined value of the decedent’s taxable estate and the donor-decedent’s lifetime gifts, which are called adjusted taxable The amount of the adjusted taxable gifts are added back to the decedent’s taxable estate. The decedent’s estate then takes a credit equal to the tentative tax on the prior gifts at the then-current transfer tax rates. [IRC 2010.] Since the assets that would be used to pay the promissory note are still held in the donor-decedent’s taxable gross estate, the Revenue Ruling concludes that the promissory note will not be treated as an adjusted taxable gift to be added back into the donor-decedent’s federal estate tax calculation. This means that the basic exclusion amount (BEA) available at the donor-decedent’s death should be large enough to cover the donor-decedent’s gift of the promissory note, which is not treated as a deductible debt when calculating the donor-decedent’s federal estate tax liability.
  • Consideration: The upshot of giving a legally enforceable promissory note at this time is that the donor will be able to take advantage of the opportunity to make gifts of up to $11.58 million while the temporary large federal gift tax exemption is available. If the goal is to have the note treated as an enforceable debt for federal transfer tax purposes then the donor needs to require some form of legal consideration from the recipient of the note. However, that consideration can be something as minimal as requiring the donee who receives the promissory note to give up smoking or drinking for six months, i.e. actions that the donee is otherwise reluctant to perform (but which consideration received by the donor does not increase the size of the donor’s taxable estate.)
  • Avoids Double Counting: The effect of the Revenue Ruling is that while the assets (available to pay the promissory note) remain part of the donor-decedent’s taxable estate and the unpaid promissory note cannot be deducted, the prior completed gift is not added back to the donor-decedent’s taxable estate as an adjusted taxable gift. Thus, the Revenue Ruling prevents the ‘double counting’ of assets in the donor-decedent’s taxable estate needed to pay the promissory note, while enabling the donor to lock in the favorable gift tax exemption amount before it expires and also permits the donor-decedent’s retained assets to receive a full income tax basis adjustment on the decedent’s death. [IRC 1014.]. In sum, the donor can promise to make a gift, via the promissory note to be paid in the future,  and currently utilize the high federal gift tax exemption to shield the value of that promised gift from gift taxation. Even if the gift is never actually made, i.e. the promissory note is not paid during the donor’s lifetime, the promissory note does not create an estate tax problem.

Valid Gift in Michigan: For a gift to be valid and enforceable in Michigan, three separate elements must be present: (i) the donor must intend to gratuitously pass ownership or title to property to the donee-recipient; (ii) there must be actual or constructive delivery of the property to the donee-recipient; and (iii) the donee-recipient must accept the gift.  In re Handlesman, 266 Mich App 433 (2005). With regard to the delivery requirement, the transfer of the property must be unconditional, and must be fully consummated during the donor’s lifetime. Restated, the property that is the subject of the gift must be in the donee’s possession and “beyond the donor’s power of recall.” Osius v.Dingell, 375 Mich 605 (1965.) A promissory note is enforceable to the same extent that a contract is enforceable. This means that the promissory note needs to be exchanged for  some consideration. Legal consideration can take a variety of legal forms, such as the performance of an act, a promise to perform a future act, or an act of forbearance by the recipient of the promissory note.

Clawback: As has been reported in the past, there is no clawback for gifts that are made under the temporary gift tax exclusion enacted by the 2017 Tax Act. Individuals who take advantage of the increased estate and gift tax exclusion, or portability, amounts in effect from 2018 through 2025 will not be adversely impacted after 2025 when the basic exclusion amount (BEA) is scheduled to drop to pre-2018 levels. [IR 2019-189.] Keep in mind, though that the temporary increase in the BEA  exemption is a ‘use it or lose it’ benefit, which mean that the gift tax exclusion used first is the initial gift tax exemption that was in place in 2017; only after that initial gift tax exemption is fully used will the temporary gift tax exemption (increased by the 2107 Tax Act) then be used by the donor to shelter lifetime transfers from the federal gift tax. Therefore, making a large gift now with a legally enforceable promissory note will use the 2017 gift tax exemption amount first; only if the promissory note exceeds the $5.1 million amount will the donor-promisor will then use their temporary gift tax exclusion amount.

Source: While Revenue Ruling 84-25 provides the basic roadmap to the tax consequences of a gift of a promissory note, the details behind the strategy of a gift of a legally enforceable promissory note are found in an extensive article written in 2012 by Austin Bramwell, Donative Promise Can Lock in 2012 Gift Tax Exemption.

Conclusion: For individuals who currently want to take advantage of the large temporary federal gift tax exemption, yet who are reluctant to part with their income producing assets as the subject of that lifetime gift, the gift of a legally enforceable promissory note makes sense. The lifetime gift does not cause harm to the donor-decedent’s estate, and the donor-decedent’s retained assets (which would otherwise have been given away as the subject of the lifetime gift) are exposed to an income tax basis adjustment at death.