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).

An Estate And An IRA Rollover

 

Retirement accounts can create headaches with the income taxation of an estate.

We know that – if one is wealthy enough – there can be an estate tax upon death. I doubt that is a risk for most of us. The new tax bill (the One Big Beautiful …), for example, increases the lifetime estate tax exclusion to $15 million, with future increases for inflation. Double that $15 million if you are married. Yeah, even with today’s prices $30 million is pretty strong.

What we are talking about is not estate tax, however, but income tax on an estate.

How can an estate have income tax, you wonder? The concept snaps into place if you think of an estate with will-take-a-while-to-dispose assets. Let’s say that someone passes away owning the following:

·       Checking and savings accounts

·       Brokerage accounts

·       IRAs and 401(k)s

·       Real estate

·       Collectibles

The checking and savings accounts are easy to transfer to the estate beneficiaries. The brokerage accounts are a little more work - you would want to obtain date-of-death values, for example – but not much more than the bank accounts. The IRAs and 401(k)s can be easy or hard, depending on whether the decedent left a designated beneficiary. Real estate can also be easy or hard. If we are selling a principal residence, then – barring deferred maintenance or unique circumstances – it should be no more difficult than selling any other house. Change this to commercial property and you may have a different answer. For example, a presently unoccupied but dedicated structure (think a restaurant) in a smaller town might take a while to sell. And who knows about collectibles; it depends on the collectible, I suppose.

Transferring assets to beneficiaries or selling assets and transferring the cash can take time, sometimes years. The estate will have income or loss while this is happening, meaning it will file its own income tax return. In general, you do not want an estate to show taxable income (or much of it). A single individual, for example, hits the maximum tax bracket (37%) at approximately $626,000 of taxable income. An estate hits the 37% bracket at slightly less than $16 grand of taxable income. Much of planning in this area is moving income out of the estate to the beneficiaries, where hopefully it will face a lower tax rate.

IRAs and 401(k)s have a habit of blowing up the planning.

In my opinion, IRAs and 401(k)s should not even go to an estate. You probably remember designating a beneficiary when you enrolled in your 401(k) or opened an IRA. If married, your first (that is, primary) beneficiary was probably your spouse. You likely named your kids as secondary beneficiaries. Upon your death, the IRA or 401(k) will pass to the beneficiary(ies) under contract law. It happens automatically and does not need the approval – or oversight – of a probate judge.

So how does an IRA or 401(k) get into your estate for income taxation?

Easy: you never named a beneficiary.

It still surprises me – after all these years - how often this happens.

So now you have a chunk of money dropping into a taxable entity with sky-high tax rates.

And getting it out of the estate can also present issues.

Let’s look at the Ozimkoski case.

Suzanne and Thomas Ozimkoski were married. He died in 2006, leaving a simple two-page will and testament instructing that all his property (with minimal exceptions) was to go to his wife. Somewhere in there he had an IRA with Wachovia.

During probate, his son (Ozimkoski Junior) filed two petitions with the court. One was for outright revocation of his father’s will.

Upon learning of this, Wachovia immediately froze the IRA account.

Eventually Suzanne and Junior came to an agreement: she would pay him $110 grand (and a 1967 Harley), and he would go away. Junior withdrew both petitions before the probate court.

Wachovia of course needed copies: of the settlement, of probate court approval, and so on). There was one more teeny tiny thing:

… Jr had called and told a different Wachovia representative that he did not want an inherited IRA.”

What does this mean?

Easy. Unless that IRA was a Roth, somebody was going to pay tax when money came out of the account. That is the way regular IRAs work: it is not taxable now but is taxable later when someone withdraws the money.

My first thought would be to split the IRA into two accounts: one remaining with the estate and the second going to Junior.

Junior however understood that he would be taxed when he took out $110 grand. Junior did not want to pay tax: that is what “he did not want an inherited IRA” means.

It appears that Suzanne was not well-advised. She did the following: 

·       Wachovia transferred $235 grand from the estate IRA to her IRA.

·       Her IRA then distributed $141 grand to her.

·       She in turn transferred $110 grand to Junior.

Wachovia issued Form 1099-R to Suzanne for the distribution. There was no 1099-R to Junior, of course. Suzanne did not report the 1099-R because some of it went (albeit indirectly) to Junior. The IRS computers hummed and whirred, she received notices about underreporting income, and we eventually find her in Tax Court.

She argued that the $110 grand was not her money. It was Junior’s, pursuant to the settlement.

The IRS said: show me where Junior is a beneficiary of the IRA.

You don’t understand, Suzanne argued. There is something called a “conduit” IRA. That is what this was. I was the conduit to get the money to Junior.

The IRS responded: a conduit involves a trust, with Junior as the ultimate beneficiary of the trust. Is there a trust or trust agreement we can look at?

There was not, of course.

Junior received $110 grand, and the money came from the IRA, but Junior was no more a beneficiary of that IRA than you or I.

Back to general tax principles: who is taxed on an IRA distribution?

The person who receives the distribution – that is, the IRA beneficiary.

What if that person immediately transfers the distribution monies to someone else?

Barring unique circumstances – like a conduit – the transfer changes nothing. If Suzanne gave the money to her church, she would have a charitable donation. If she gave it to her kids, she might have a reportable gift. If she bought a Mercedes, then she bought an expensive personal asset. None of those scenarios keeps her from being taxed on the distribution.

Here is the Court:

What is clear from the record before the Court is that petitioner’s probate attorney failed to counsel here on the full tax ramifications of paying Mr. Ozimkoski, Jr., $110,000 from her own IRA.”

While the Court is sympathetic to petitioner’s argument, the distributions she received were from her own IRA and therefore are considered taxable income to her …”

She was liable for the taxes and inevitable penalties the IRS piled on.

Was this situation salvageable?

Not if Junior wanted $110,000 grand with no tax.

It was inevitable that someone was going to pay tax.

If Junior did not want tax, the $110 grand should be reduced by taxes that either Suzanne or the estate would pay on his behalf.

If Junior refused, then the settlement was not for $110 grand; it instead was for $110 grand plus taxes. That arrangement might have been acceptable to Suzanne, but – considering that she went to Tax Court – I don’t think it was.

The Court noted that Suzanne was laboring.

… she was overwhelmed by circumstances surrounding the will contest.”

While the Court is sympathetic to petitioner’s situation …”

Let me check on something. Yep, this is a pro se case.

Suzanne was relying on her probate attorney for tax advice. It seems clear that her attorney did not spot the issue. I would say Suzanne’s reliance on her attorney was misplaced.

Our case this time was Suzanne D. Oster Ozimkoski v Commissioner, T.C. Memo 2016-228.

An Ugly Case Over An Ugly Penalty

 

You know that the IRS pays especial attention to foreign transactions of U.S. citizens. We are to report foreign bank accounts, for example, should they exceed a certain balance.

Did you know that you may also have to report gifts made to you by individuals (and entities) overseas and exceeding certain threshold amounts?

That may come as a surprise, as we anticipate gifts to be tax free (and unreported) by the recipient. To the extent we pay attention to this area of tax, it is the donor - not the donee - who reports a gift. It is even possible to have a tax (the gift tax) if one cumulatively gifts “too much” over a lifetime.

Let’s be candid here: this is not a risk you or I have to sweat.

What got me thinking about it is a recent case coming out of California. Ms. Huang litigated over IRS penalties for her failure to timely report gifts from her overseas parents. She used TurboTax to prepare her taxes, and TurboTax advised her incorrectly about the gifts. She believes she has reasonable cause for abatement of those penalties.

I agree with her.

I also think this area of tax law is a mess.

Let’s go over this – briefly.

First, there are two considerations with foreign gifts:

·       Disclosure

·       Taxation

It is unlikely that there will be a tax, but it is likely that you must report the gift. There is even a specialized form for this – Form 3520: 

Trust me, one can have a long career in public accounting and never see this form.

The filing threshold varies depending on the donor:

Gifts From Foreign Individuals

·       The threshold is $100,000. Not surprisingly, multiple gifts from the same person (say mom) must be added together.

o   BTW, if mom gets creative and arranges to transfer more than $100 grand via various family members, there is a related party rule that will combine all those donors into one person – and put you over the $100,000 threshold.

o   Once required to file, each gift of $5 thousand or more is to be separately identified and described.

o   There may be excellent reasons for the multiple gifts. There are numerous countries which impose restrictions on outbound currency transfers. South Korea, for example, places a limit of $50,000 (USD).

Gifts From Foreign Corporations or Partnerships

·       The reporting threshold is greatly reduced if a business entity is involved – to $19,570.

·       In addition to the usual gift information, one is also to provide the name, address, and tax identification number (if such exists) for the entity.

Inheritances

The IRS takes the position that an inheritance is comparable to a gift. If one inherits from a nonresident, the inheritance might be reportable on Form 3520.

EXAMPLE: Carlos is a lawful permanent resident of the U.S. His uncle – a nonresident alien - passes away, leaving Carlos a house in a foreign country. While the residence is outside the U.S., Carlos is a U.S. permanent resident and should file a Form 3520.

Let’s change the example a little bit:

EXAMPLE: Carlos’ uncle was also a lawful permanent resident of the United States, even though he lived for substantial periods outside the U.S. The inheritance now is from one “US person for tax purposes” to another, and there is no need to file Form 3520.

  The penalties for not filing a 3520 can be onerous.

·       5% of the gift amount for each month a failure to file exists. In the spirit of not bayoneting the dead, the IRS will (fortunately) stop counting once you get to 25%.

·       If the IRS contacts you before you contact them, the penalty changes. It then becomes $10,000 for each month you fail to file Form 3520 after request.

·       Penalties will apply even if you filed a 3520, if the IRS believes that the return is incomplete or incorrect.

·       BTW this penalty can chase you unto death – and beyond. There are cases where the IRS has demanded penalties from the estates of deceased individuals.

So, what happened to Ms. Huang?

Her name is Jiaxing Huang, and in 2015 and 2016 her parents gifted substantial sums to help her relocate to the U.S. and purchase a home. Ms. Huang, like millions of others, used TurboTax to prepare her taxes for those years. She asked - and TurboTax informed her - that donors, not donees, are required to report gifts. Based on that feedback, she did not file Form 3520 for those years.

COMMENT: TurboTax was correct, IF one was talking about gifts from a U.S citizen or lawful permanent resident to another. It was not correct in specialized circumstances – such as that of Ms. Huang’s.

A couple of years later she learned of her filing obligations. Trying to play by the rules, she immediately filed Form 3520 for 2015 and 2016. She was late, of course, but she filed before the IRS ever contacted her – or had any reason to suspect that she was even required to file.

The IRS responded – here is a (too) common reason people hate the IRS – with penalties exceeding $91 grand.

COMMENT: The IRS churns these letters automatically. They do not go by human eyes. I propose – as a small improvement – that the someone at the IRS review these letters and related files before sending out such onerous penalties. I understand workforce limitations, but let’s be blunt: HOW MANY NOTICES CAN THERE BE?

Ms. Huang submitted an abatement request based on reasonable cause.

The IRS denied the request. They then withheld her 2019 ($280) and 2022 ($7,859) tax refunds.

Of course.

She appealed the denial of abatement within the IRS itself.

COMMENT: She was trying.

She instead learned that her penalty had jumped to over $153 grand. With interest she was topping $190 grand.

This was so egregious that even the IRS backed down. Appeals reduced the penalty to slightly over $36 grand.

Ms. Huang paid it.

COMMENT: No!!!!!

Two weeks later she filed a Claim for Refund.

COMMENT: Yes!!!!!

Her grounds? Abatement of the penalties – as well as the 2019 and 2022 tax refunds the IRS intercepted.

Let’s take a moment to explain why Ms. Huang paid the penalty.

In many if not most areas of tax law, one can bring suit without paying the tax (or penalty or whatever). That is one of the attractions of the Tax Court: you can get a hearing before sending the IRS a nickel. Not all areas of tax law are like this, however. An area that is not? You guessed it: Form 3520 penalties.

COMMENT: If you think about it, this is one way to keep people from bringing suit. How many can afford to pay the tax (or penalty or whatever) AND pay a tax attorney to litigate? It’s a nice scam you have there, Agent Smith.

The government did its usual: an immediate motion to dismiss the complaint. They even offered four reasons why the Court should dismiss.

The Court agreed with the government on three of the reasons.

It did not agree with the fourth: whether Ms. Huang’s reliance on tax software such as TurboTax under these circumstances could constitute reasonable cause.

Ms. Huang will have her day in Court.

But at what cost to her.

And why – when the IRS is hemorrhaging employees and losing budget allocations it likely should not have received in the first place – are they wasting their time here? The facts are unattractive. Ms. Huang is not a protestor or scofflaw. She tried. She got it wrong, but she tried. There is no win condition here for the government.

Our case this time was Jiaxing Huang v United States, Case No 24-cv-06298-RS, No District California.