In a recent U.S. Tax Court case, Estate of Barbara Galli, Deceased, Stephen R. Galli, Executor, et al. v. Commissioner of Internal Revenue, the court addressed a tax dispute involving a $2.3 million purported loan transfer between Barbara Galli and her son, Stephen, in 2013. The case, decided via summary judgment, centered on whether this transfer was a loan, a gift, or a partial gift. Since the IRS did not assert that the entire transaction was not a loan but instead was a part loan/part gift, the court found no gift at all because the loan documents provided for adequate interest under Section 7872.
FACTS: Barbara Galli, who passed away in Florida in 2016, transferred
$2.3 million to her son, Stephen, in 2013. The transfer was documented as a
loan with a 9-year term and an interest rate of 1.01%, matching the mid-term
Applicable Federal Rate (AFR) at the time. The loan was unsecured, lacked
standard commercial enforcement provisions, and required annual interest
payments with the principal due at the end of the term. Stephen made interest
payments in 2014, 2015, and 2016, and the unpaid loan was included in Barbara’s
estate tax return, valued at $1.624 million. The premise of the IRS’ claim was
that there was a question about whether Stephen had the financial wherewithal
to repay the loan, and thus the principal amount should be discounted by
appraisal taking into the ability to repay. The excess of the principal amount
over the discounted value was asserted to be a taxable gift. Bolstering its
argument, the IRS sought to apply the consistency doctrine, since Barbara’s
estate reported a lower than face value amount as to the value of the note for
estate tax purposes, taking into account similar considerations that warranted
a reduced value for the note. The taxpayer moved for summary judgment on the
gift issue citing Frazee v. Commissioner (1992), which held that §7872
provides comprehensive treatment for loans at or above the AFR for both income
and gift tax purposes, displacing traditional fair market valuation methods for
gift tax purposes. The court agreed, also acknowledging that the consistency
doctrine did not apply due to the different rules that applied under §7872 versus
estate tax valuation.
COMMENTS: There are several takeaways from this case. The first is that
the court accepted the premise of the taxpayer’s argument that traditional
valuation principles that value a promissory note for estate tax purposes,
which include judgments relating to the likelihood of repayment, do not apply
in determining whether a loan transaction constitutes a partial gift if there
is loan and it is not considered a below-market loan under §7872. Secondly, if
the IRS could have shown that there was no valid loan element at all, then §7872
would not apply and presumably the entire transfer would have been a taxable
gift. Therefore, if factually there are substantial questions about whether
loan treatment at all is proper, a gift can result. In this case, even though
the note was unsecured, that the interest was timely paid was probably a useful
fact in this regard. The decision can provide some comfort to taxpayers that
there appears to be an all or nothing approach to the IRS being able to obtain
gift treatment if there is adequate interest under §7872 but there may be some question as to ability
to repay– assuming adequate interest either the transaction is entirely free of
gift tax as a loan, or fully a gift if it can be shown that there was no bona
fide loan at all. This case can be compared to Estate of Bolles v. Comm’r,
133 AFTR 2d 2024-1235 (9th Cir 2024), affirming TC Memo 2020-71, in
which loans were entirely reclassified as gifts where there were no repayments
and there was evidence of lack of ability of the borrower to repay the loans.
CITES:
Estate of Barbara Galli v Comm’r, Docket Nos. 7003-20 and 7005-20 (March
5, 2025); Frazee v. Comm’r, 98 T.C. 554 (1992); Estate of Bolles v.
Comm’r, 133 AFTR 2d 2024-1235 (9th Cir 2024), affirming TC Memo
2020-71; Code § 7872.
