An Intrafamily Loan, A Death And A Reportable Gift

 

Let’s talk about a (somewhat) high-end tax strategy: intrafamily loans.

At its core, it involves wealth and the transfer of wealth within a family.

Let’s walk through an example.

You want to help out your son. Your attorney or CPA mentions that one way is to loan money and charge your son as low an interest rate as possible. The fancy word for this is arbitrage, and it is how a bank makes money.

Let’s go with an easy example:

·       You loan the money at 2.45%.

·       Your son can invest in a CD at 5.45%

We are arbitraging 3 points, meaning $3 grand per $100 thousand.

Lend $1 million and you have moved $30 grand.

What is the term of the loan?

Coincide it with the term of the CD.

Let’s say 5 years.

I am seeing you move $150 grand ($30,000 times 5 years).

Then what?

He pays you back $1 million when the CD matures.

How does the IRS view intrafamily loans?

With suspicion. The IRS has multiple points of interest here.

·       Are you reporting the interest income for income tax purposes?

·       Is there a gift component to this? If so, have you filed a gift tax return?

·       If you die with the loan outstanding, is the loan properly reported and valued on the estate tax return?

·       If the loans involve grandchildren, are there generation-skipping tax considerations? If so, have you filed that return?

The IRS’ primary line of attack will be that the debt is not bona fide. How do you know if it is or isn’t? The landmark case in this area is Miller v Commissioner, and the Tax Court looked at nine factors:

·       Is there a written promissory note?

·       Is adequate interest being charged?

·       Is there security or collateral for the loan?

·       Is there a maturity date?

·       Is there a believable demand for repayment?

·       Is the loan being repaid?

·       Can the borrower repay the debt?

·       Have you created and maintained adequate records?

·       Have you properly reported the loan for tax purposes?

The closer you get to a bank loan, the better your odds of defeating an IRS challenge. There is tension in this area, as courts will tell you that an intrafamily loan does not need to rise to the underwriting level of a bank loan while simultaneously testing whether an actual loan exists by comparing it to a bank loan.

Let’s go through our CD example. What can we do to discourage an IRS challenge?

·       We can create a written promissory note.

·       We will look at the Galli case in a moment to discuss adequate interest.

·       We probably will not require collateral.

·       The loan is due when the CD matures.

·       It is not our example, but a common way to show repayment intent is to amortize the debt: think monthly payments on a house or car.

·       The loan will be repaid when the CD matures.

·       Probably. Your son never had a chance to spend the loan amount.

·       Let’s say you have good records.

·       Let’s say you use a competent tax practitioner.

Let’s review the Estate of Barbara Galli case to discuss adequate interest.

In 2013 Barbara Galli lent $2.3 million to her son Stephen. They paid attention to the Miller factors above: a written note, paying 1.01% interest and due in nine years. Stephen paid the interest reliably and Barbara reported the same as income on her tax return.

Barbara passed away in 2016.

The IRS challenged the loan for both estate and gift tax purposes. The two cases (one for gift and another for estate) were consolidated by the Tax Court for disposition.

Here is the IRS:

·       The loan was unsecured and lacked a legally enforceable right to repayment reasonably comparable to the loans made between unrelated persons in the commercial marketplace.

·       It has not been shown that the borrower had the ability or intent to repay the loan.

·       It has not been shown that the decedent had the intent to create a legally enforceable loan, or that she expected repayment.

·       The decedent did not file a gift tax return relating to the loan.

·       The estate valued the note for tax purposes at $1,624,000.

The IRS points are predictable.

Note that Barbara did not file a gift tax return. This is because she did not consider herself as having made a gift. She instead had made a loan, with interest and repayment terms. In retrospect, she should have filed a gift tax return, if only to start the statute of limitations. The return might look odd if the loan were the only item reported, as the amount of reportable gifts would be zero. It happens. I have seen gift tax returns like this.

I suspect however that it was the last factor - the difference in values - that caught the IRS’ attention. The IRS saw a loan of $2.3 million. It then saw the same loan reported on an estate tax return at $1.624 million.

Now the IRS was in Tax Court trying to explain why and how they saw a gift rather than a loan.

The amount by which the value of money lent in 2013 exceeds the fair market value of the right to repayment set forth in the note is a previously unreported and untaxed gift. 

The Court was confused. Its reading (and mine) of the above is that the IRS wanted the difference between the two numbers to be the gift and not the original $2.3 million.

How can we get to the IRS position?

The easiest way would be to charge inadequate interest. The inadequate interest over the life of the loan would be a gift.

Bad argument, however. There used to be endless contention between the IRS and taxpayers on loans and adequate interest. In some cases, the IRS saw additional compensation; in others it saw reportable gifts. In all cases, taxpayers disagreed. There was constant litigation, and Congress addressed the matter during the Reagan administration with Section 7872.

    26 U.S. Code § 7872 - Treatment of loans with below-market interest rates

              

This Section introduced the concept of minimum interest rates, which the IRS would publish monthly. Think of it as a safe harbor: as long as the loan used (at least) the published rate, Congress was removing the issue of adequate interest from the table.

Let’s look at these rates for February, 2013.

                       REV. RUL. 2013-3 TABLE 1

 

           Applicable Federal Rates (AFR) for February 2013

  _____________________________________________________________________

                                       Period for Compounding

                          _____________________________________________

  

                         Annual    Semiannual  Quarterly    Monthly

  _____________________________________________________________________

  

                              Short-term

  

      AFR                 .21%        .21%        .21%        .21%

 

                               Mid-term

  

      AFR                1.01%       1.01%       1.01%       1.01%

 

Barbara made a nine-year loan, which Section 7872 considers “mid-term.” The published rate is 1.01%.

What rate was Barbara was charging Stephen?

1.01%.

Coincidence? No, no coincidence.

 Here is the Court:

We reiterated the point later … by concluding that ‘Congress indicated that virtually all gift transactions involving the transfer of money or property would be valued using the current applicable Federal rate …. Congress displaced the traditional methodology of valuation of below-market loans by substituting a discount methodology.'

To sum up, the issue on these motions are whether the transaction was a gift, a loan, or a partial gift. We determine that the Commissioner is not asserting that the transaction was entirely a gift and would lose on the proof if he were. This leave us to apply section 7872, and under that section, this transaction was not a gift at all.”

The IRS lost. I would say that Section 7872 did its job.

Our case this time was Estate of Galli v Commissioner, Docket Nos 7003-20 and 7005-20 (March 5, 2025).