Take-Away: Many estate planning transactions use debt or loans between family members or between related parties. The existence of a bona fide debt is critical to the effectiveness of the transaction. If the loan is not repaid, the question arises if the holder of the promissory note is entitled to claim a tax deduction for a worthless debt. That was the question in a recent Tax Court Memorandum decision.

Background: A common estate planning technique during periods of low interest rates is a loan of funds from parents to children or grandchildren, who in turn invest those funds and earn the difference on the ‘spread’ of the investment return over the anticipated much lower minimum interest rate (AFR) that has to be charged on the loan. If the intra-family loan is not respected, it will be treated as a taxable gift from the parent to the child or grandchild. Another estate planning technique that requires the use of a ‘valid’ promissory note is when an individual sells an asset that is likely to appreciate in value to a grantor trust in exchange for the promissory note from the trustee of that grantor trust. The validity of the trustee’s promissory note is critical if that sales transaction is to be respected by the IRS. In short, for the shift of wealth to occur tax-free, the underlying debt must be valid and enforceable.

Tax Court Case: 2590 Associates, LLC v. Commissioner, Tax Court Memo, 2019-3. Dec. 61,404 (M), February 1, 2019.

Issue: The issue before the Tax Court was whether an LLC would be entitled to claim an income tax deduction for a worthless debt when it loaned funds to a related party. The Tax Court found the debt to be bona fide and thus the bad debt income tax deduction claimed by the LLC was permitted.

Structuring the Loan Transaction: In reaching this favorable outcome for the LLC, the Tax Court focused on a number of factors to support its conclusion that the loan transaction between related parties was valid (which is equally important in intra-family loan transactions to avoid an imputed taxable gift.) The factors stressed by the Tax Court to find a valid loan (and not an implied gift) which thus resulted in an income tax loss for the note holder included the following:

  • The debt was evidenced by a promissory note;
  • The promissory note had a fixed maturity date;
  • The rate of interest on the promissory note was set at an above-market interest rate;
  • The lender intended to collect the note and believed that the borrower would repay the note;
  • The lender possessed the legal right to enforce collection of the note;
  • If there was a default in the payment under the note, a higher default interest rate would apply on the unpaid principal balance;
  • If there was a default in the payment under the note, the lender was entitled to collect attorney’s fees;
  • The repayment of the note was not limited solely to the income from the borrower; and
  • The borrower was not thinly capitalized, which was confirmed by an appraisal of the borrower obtained by an unrelated lender, which appraisal indicated that the borrower had substantial equity.

No Collateral: In a bit of a surprise, this favorable result for the LLC was achieved despite the fact that the promissory note was unsecured. The existence of collateral to secure the repayment of the promissory note is usually one of the key factors that the Tax Court looks for to find a valid ‘debt’ (and not an informal gift.)

Conclusion: If individuals contemplate intra-family loans to take advantage of the very low prevailing applicable federal interest rates, e.g. a loan today for less than 3 years requires a minimum 2.37% interest rate, it is important that the lender follow these important formalities to document, and to secure, the loan to avoid an implied taxable gift. Or, as indicated in this recent Tax Court decision, the lender’s ability to claim a bad debt income tax deduction if the debtor fails to repay the loan.