Tax Court Gives Split Decision in Gift vs. Loan Case

As shown by a new case, Bolles, TC Memo 2020-71, 6/1/20, the Tax Court will look to the particular circumstances to make a determination between a gift and a loan.

Jul 6th 2020
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Suppose a client transfers money to a child to help with a down payment on a home or a business venture. Is it a gift or a loan? There are tax consequences to this distinction.

The tax rules for intra-family loans are complicated. For starters, there is no problem whatsoever if the loan amount is for $10,000 or less. Both parties are completely in the clear.

However, if the borrowed amount exceeds $10,000 and the lender doesn’t charge any interest (or interest below the going rate), the IRS will “impute” interest income to the lender. If the loan amount is for $100,000 or less, the interest the lender is treated as having received is limited to the borrower’s  net investment income for the year. Furthermore, if the net investment income doesn't exceed $1,000, no interest is imputed.

In contrast, a gift results in potential gift tax liability to the giver. (There are no tax implications for the recipient). Typically, the gift may be sheltered from gift tax by the annual gift tax exclusion ($15,000 per recipient for 2020).  If the gifts exceed this amount, it can be covered by the unified estate and gift tax exclusion. 

The exclusion was recently doubled from $5 million to $10 million and indexed for inflation. It’s $11.58 million in 2020. But the exclusion is scheduled to revert to $5 million in 2026.

Any amount used for lifetime gifts erodes the remaining estate tax shelter. When large amounts are involved, the tax difference between intra-family loans and gifts can be significant.

In the new case, the decedent made transfers to several children. Notably, she transferred substantial amounts of money to one son after he ran into financial problems running the architectural firm he took over from his father. Between 1985 and 2007, these transfers totaled $1.06 million.

The decedent didn’t have her son sign a promissory note for the transfers. But she did keep track of the amounts and logged in repayments and forgiveness of the loans each year based on the annual gift tax exclusion.

Initially, the decedent thought her son would be able to repay the advances in full and treated them as loans. However, it became clear by 1989 that would not be the case and the firm eventually folded.

When the decedent died in 2010 and the IRS assessed a $1.15 million estate tax deficiency, based on the premise that the entire $1.06 million transferred to her son constituted loans. The estate contended that the transfers of the entire $1.06 million were gifts, so the principal and any accrued interest should be excluded from the taxable estate.

After examining the facts, the Tax Court concluded that approximately $425,000 in advances transferred by the decedent prior to 1990 were, in fact, loans that she reasonably expected her son to repay. However, any transfers made after 1990 were gifts because she had no reasonable expectation of repayment.

Moral of the story: Have clients keep detailed records of intra-family transactions. If transfers are intended to be treated as loans, they should impose standard loan terms such as a repayment schedule and charge interest evidenced by a promissory note. By strictly adhering to the rules, you can avoid dire tax consequences in the future.

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