A Loan or a Gift?

Take-Away: Towards the end of 2020 substantial gifts were made in anticipation of a change in the federal transfer tax laws with a change in administrations. Intra-family loans were made to exploit the low interest rate environment to shift wealth gift tax-free. 2021 may prove to be no different. A parent’s inclination to help a child or grandchild who is struggling financially with a loan can sometimes inadvertently trigger a federal gift tax.

Background: A couple of notable 2020 Tax Court decisions are helpful reminders some important principles with regard to transfers of wealth that come into play with lifetime loans and gifts.

Burt Kroner v. Commissioner, Tax Court Memo, 2020-73 (June 1, 2020): When does a gift become taxable income to the donee?

• Law: As a general proposition, gifts are excluded from the recipient’s gross income. [IRC 102(a).] In this case the Tax Court had to decide whether transfers made to Burt were gifts or they should have been included in Burt’s taxable income.
• Facts: Burt had a business relationship with David, which he claimed developed into a long-standing friendship. Burt and David were co-investors and business partners at various times over the past 30 years. Between 2005 and 2007, at a time when Burt and David had no direct business ventures together, David made substantial ‘gifts’ to Burt. David was a British citizen at the time of the transfers. Burt’s attorney, who was also David’s attorney, advised Burt that the transfers were gifts and therefore excludable from Burt’s taxable income under IRC 102(a). Burt was advised to report the transfers as foreign gifts. [Form 3520.] Burt’s accountant did not report the transfers as income. Burt was subsequently audited and an income tax deficiency was asserted in 2014. Burt was also tagged with accuracy-related penalties. [IRC 6662.]
• Tax Court: The Court had to determine David’s intent when he made the transfers to Burt. The Court noted that under IRC 102(a) a transfer must be made with detached and disinterested generosity to,  be excluded from income. Only Burt and his attorney testified, which the Court found to be self-serving, unsubstantiated and unconvincing. With regard to the question before it the Court found: (i) Burt and David only had a business relationship; friendship did not explain the large transfers from David to Burt; (ii) the timing of the gifts from David to Burt correlated with liquidity events for David, which the Court suggested could indicate that David was acting as a nominee for Burt, making investments for Burt because Burt was barred by non-competition agreements from investing in some of the liquidating companies. As a result, the alleged gifts were actually taxable income paid to Burt. However, Burt did escape the accuracy-related penalty on a technicality.

Estate of Mary Bolles v. Commissioner, Tax Court Memo, 2020-71 (June 1, 2020)  When does a loan become a gift?

• This decision was summarized several months ago, so it may sound familiar.
• Law: The IRS, and the U.S. Tax Court, often refer to a 1997 decision which identified several factors that need to be consider to determine whether the transfer of wealth is a gift or a loan. Miller v. Commissioner, Tax Court Memo 1996-3, affirmed 113 F.3d 1241 (9^th1997.)  Those factors include whether: (i) there was a promissory note or other evidence of indebtedness; (ii) interest was charged; (iii) there was security or collateral furnished; (iv) there was a fixed maturity date; (v) a demand for repayment was made; (vi) actual repayment was made; (vii) the recipient or transferee had the ability to repay; (viii) records were maintained by the transferor and/or the transferee that reflect the transaction as a loan; and (ix) the manner in which with a  the transaction was reported for federal tax purposes was consistent with a loan.
• Facts: Unlike Kroner, in this case the transfers were between family members. Mary died in 2010. When her estate tax return was audited, the IRS noted that Mary had made over the course of 20 years several gifts to her son, Peter, who had a San Francisco architecture business, following in his father’s footsteps. Those transfers amounted to over $1.06 million. The IRS claimed that the gifts Mary had made to Peter were actually loans which should have been included in her taxable estate. [IRC 2031] None of the transfers to Peter were subject to written loan agreements, nor were they any attempts or requests by Mary for a repayment. However, Mary did informally keep track of the amounts that she gave to Peter and the interest that accrued on those transfers. Mary had other children besides Peter and she periodically advanced funds to all of her children, including when other children would repay her. Mary also forgave loan amounts to her children each year in keeping with the gift tax annual exclusion amount, i.e. $15,000 each year for each child. Peter encountered financial difficulties with his architecture business and he failed to make any repayments of the ‘loans’ to Mary.

With the loans to her children as context, Mary created a revocable trust in 1989 in which she specifically excluded Peter from any distributions from her estate on her death. About six years later that trust was amended to no longer exclude Peter as a beneficiary; it was replaced with a formula bequest to account for the loans made to Peter during Mary’s lifetime, plus accrued interest.

• Tax Court: The Court observed that with regard to the loans made by Mary to all five of her children, “[Mary’s] practice would have been noncontroversial but for the substantial funds she advanced to Peter.”

An actual expectation of repayments and intent to enforce the debt are critical to characterizing an intra-family loan. “In the case of a family loan, it is a longstanding principle that an actual expectation of repayment and an intent to enforce the debt are critical to sustaining the tax characterization of the transaction as a loan.” The Court found that while Mary had initially expected repayments because she thought Peter’s business would ultimately prove to be successful, after 1989 it became clear to Mary that Peter’s business was in significant financial difficulties. When Mary adopted her revocable trust in 1989 and excluded Peter as a beneficiary was a key indicator to the Court that Mary’s expectation that Peter could repay the advances from his mother had changed. After 1989 those advances lost the characteristics of loans for tax purposes and were gifts to Peter because Mary then realized that she was unlikely to be repaid.

In the end, the Court ‘split the baby’ in its decision. Those advances made by Mary to Peter before 1990 were treated as outstanding loans to be included as assets in Mary’s taxable estate. Nothing was said with regard to the value of those ‘old and cold’ loans. The advances Mary made to Peter starting in 1990 were treated as gifts by her, which were not included in her taxable estate.

Conclusion: The current low interest rate environment is attracting a lot of intra-family loans to shift wealth gift-tax free. The threat of a sudden drop in the federal transfer tax exemption amount is prompting many wealth individuals to make gifts at this time to remove appreciating assets from their taxable estate. The Bolles decision is a helpful reminder that reinforces the importance of having written loan documents, security for the loan, and a debtor who has the ability to repay the advance. The Kroner decision reminds us that just because we want to call a transfer of wealth a gift, does not mean that the IRS will willingly go along with that classification.