Take-Away: With interest rates so long, intra-family loans using those low interest rates have garnered interest. Sometimes, however, the IRS claims that the loan is really a taxable gift. How the transaction is structured and reported will go a long way to demonstrate that no gift was intended.

Background: The US Tax Court has often ruled on whether a loan is actually a gift. In Miller v Commissioner, Tax Court Memo, 1996-3, affirmed 113 F. 3d 1241 (9th Cir. 1997) the Tax Court identified the traditional factors that it uses to decide whether an advance is a loan or a gift. The factors regularly identified by the Tax Court  to find a loan include the following:

  • There was a promissory note or other evidence of indebtedness
  • Interest was actually charged on the loan
  • There was security or collateral furnished for the loan
  • There was a fixed maturity date for the loan
  • A demand for repayment was made by the lender
  • Actual payment was made by the borrower
  • The borrower had the ability to pay the loan
  • Records maintained  by the lender and the borrower reflect the transaction as intended to be a loan; and
  • The manner in which the transaction was reported for federal tax purposes is consistent with a loan.

The Tax Court follows a longstanding principle that an actual expectation of repayment and an intent to enforce the debt are critical to sustain the tax characterization of the transaction as a loan. That principle was on display in a Tax Court decision from last month.

Bolles v. Commissioner: In a recent Tax Court decision, Bolles v. Commissioner, Tax Court Memo, 2020-71 the question before the Court was whether the transfers made over several years by the mother, Mary, to her son, Peter, a promising architect who followed in his deceased father’s footsteps, were gifts or loans? Both, according to the Tax Court.

  • Facts: From 1985 through 2007 Mary transferred $1,063,333 to Peter, one of her five children. Peter did not repay his mother after 1988, although he was gainfully employed for many years as an architect both in San Francisco and Las Vegas. It became apparent by 1989 that Peter chronically struggled financially and was unable to timely make payments on the ‘loans’ that he received from his mother. In 1995 Peter  signed an Acknowledgement that he had received loans from his mother that he was unable to pay but that, irrespective of the collectability of the loans, the unpaid amount, plus interest accruing at the AFR short-term rate, would be subtracted from the amount Peter would otherwise be eligible to receive on his mother’s death from her Trust as his share of her estate.

On Mary’s death her Trust described the manner in which she made advances to her children, which were described as ‘loans’ that were to be taken into account in dividing her Trust assets among her  5 children in shares of equal value upon her death. After the payment of estate taxes, each child’s share of Mary’s Trust estate was reduced, and that amount redistributed pro rata among the other beneficiaries by the amount of  that child’s outstanding loans, plus accrued interest at the AFR rate. Consequently, Mary’s Trust did not single out her loans solely to Peter; rather, it referred to loans outstanding to any trust beneficiary on Mary’s death.

  • IRS: The IRS issued a Notice of Deficiency for Mary’s estate. The IRS used an either/or approach to this Notice of Deficiency. Either the fair market value of Peter’s promissory notes and receivable was $1,063,333, instead of $0.00 as reported, that should have been included in Mary’s estate under IRC 2031, plus the interest accrued on those notes in the amount of $1,165,778 [IRC 2033] for a total additional asset included in Mary’s taxable estate of $2,229,111, or, if the notes and accrued interest on the notes are valued at $0.00, then those adjusted lifetime taxable gifts to Peter in the amount of $1,063,333 should be included in the tax base used to calculate Mary’s estate tax liability. [IRC 2001(b).]
  • Tax Court: The Tax Court held that while Mary had recorded the advances to Peter as loans and that she kept track of the interest accruing on the loans, there was no formal loan agreement or promissory note, nor any attempts by Mary to enforce repayment from Peter.

Intent: On the difficult issue of determining Mary’s intent, the Court ultimately determined that Mary expected Peter to make a success of his architectural practice in San Francisco as his father had, and she was slow to abandon that expectation.

Trust Amendment: However, the Court also found that by October, 1989 Mary had come to realize that Peter was very unlikely to repay the loans she made to him, when her Trust was amended to add the ‘offset’ formula provision for unpaid loans to children that existed at the time of Mary’s death.

Split Decision: Accordingly, the Tax Court found that by 1990 the loans made to Peter lost that characterization for tax purposes and they became advances of Peter’s ultimate inheritance from Mary. Therefore, the Court found that Mary’s advances to Peter were loans through 1989, but after that year they were gifts. The Court considered whether Mary forgave any of the prior loans in 1989, but it found that she did not forgive the loans but rather she accepted that they could not be repaid on the basis of Peter’s financial distress. In sum, the Court tended to ‘split the baby’ with its factual findings with regard to Mary’s intent. Some of the stale loans to Peter plus accrued interest were included in Mary’s taxable estate as assets, and some of the later-year  loans Peter received were treated as lifetime gifts/advancements by Mary. This dual treatment was ultimately to Mary’s estate’s benefit, as larger loan/advancements were made in later years.

Conclusion: These loan-or-gift cases tend to be highly fact specific. What is important to keep in mind are the factors that the Court will look for to find that an enforceable loan was intended. With the renewed interest in exploiting the very low AFR rates of interest to be used in intra-family loans, documenting the Miller factors will be important to prove that a loan, and not a gift, was intended.