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Wednesday, September 23, 2020

New Case on Loan vs. Gift

 In a low-interest rate environment, loans by wealthy parents to children often makes sense from a planning perspective. If the recipient can invest the proceeds and earn more than the low interest rate charged, the net profit is effectively transferred without a taxable gift.   

It is important that the loan be respected as a loan and not a gift. A recent Tax Court Memorandum decision dealt with this issue. In the case, the taxpayer had made significant loans over time from 1984 to 2007. The issue was whether these were bona fide loans or taxable gifts.   

The Tax Court noted the traditional factors in determining whether a transfer is a loan or a gift - namely these factors support a loan: ( 1) there was a promissory note or other evidence of indebtedness, (2) interest was charged, (3) there was security or collateral, (4) there was a fixed maturity date, (5) a demand for repayment was made, (6) actual repayment was made, (7) the transferee had the ability to repay, (8) records maintained by the transferor and/or the transferee reflect the transaction as a loan, and (9) the manner in which the transaction was reported for Federal tax purposes is consistent with a loan. The Tax Court also noted that in a family loan situation, an actual expectation of repayment and an intent to enforce the debt are critical to loan treatment.   

In the case, it was noted that advances to the son began when he began his career as an architect. The court noted that there was an expectation that the son would have a successful career and would be able to repay the note. Over time, however, events occurred that created doubt on whether the loans would be repaid, including the default by the son's business on business loans and the failure of the business. In 1989, the taxpayer excluded the son from inheriting assets under her revocable trust agreement. In the mid-1990's, the taxpayer's estate planning documents and related agreements noted that the son did not have and was not expected to have in the future, earnings capacity so as to repay the notes. Thus, "an actual expectation of repayment" became a key issue. Based on this change of events, the Tax Court found that there was an expectation of repayment through 1989, and treated the advances through then as loans. However, that expectation of repayment was found to have disappeared after that, and the court found the advances made after 1989 were gifts.   

 Estate of Mary Bolles, TC Memo 2020-71  


Unknown said...

In the above case what if the parents originally designated it as a Generation-skipping transfer (Form-709). Would that have eliminated the problem.
If so could you address this specifically as many of us are at that age where we would like to dispense of significant cash holdings to our adult children/gran-kids without generating a taxable event per se.
Pat Lewis

Charles (Chuck) Rubin said...

A loan makes sense when the parent doesn't have sufficient unified credit exemption left to avoid gift tax, or otherwise doesn't want to use whatever exemption exists. So if they color it as a loan, they want it to stand up as a loan, which is what the case is about.

Designating it as a skip on a return means that it was a taxable transfer and not a loan, and that would thus defeat the planning. So I'm not sure how that would help on this particular issue.

As noted, if the parent has enough exemption, then they could do a straight gift and avoid a loan, and use the exemption before the exemption amount potentially gets reduced in the future. If the transfer is made to a dynasty-type trust, and GST exemption is allocated, then that will allow the trust to continue down the generations until consumed without a transfer tax.