Intra-Family Loan: A Gift Alternative In Turbulent Times?

September 28, 2020

Woe to Us?

We live in strange times.

The coronavirus pandemic hit the United States hard, the scientific community fears a second round later this year, and there have been wildly differing estimates over when an effective vaccine may be available.

Millions of Americans remain unemployed and are struggling to stay afloat, approximately one hundred thousand small businesses have already been lost and others are sure to follow, cities are eerily quiet as millions of office workers have adapted to conducting business remotely,[i] long-standing issues of economic inequality and discrimination have found new voices, generating sometimes violent protests across the country, and many who can relocate to more rural (even foreign) areas to ride out the “storm” have done so.[ii]

Notwithstanding the foregoing circumstances, Congress is unable to produce an economic stimulus measure or any social welfare package because of competing political “ideologies,” partisan politics, and election-year posturing.[iii]

We seem to be at odds with most of the world, the nation’s chief executive has intimated that he may not accept the results of the upcoming general election, Congress and former Pentagon officials are openly concerned about the role the military may be called upon to play in the aftermath of the election.[iv]

Oh, I almost forgot, we face the prospect of significant increases in the federal gift and estate taxes in the near future.

Life Goes On

In light of the general uncertainty surrounding us, many relatively well-off taxpayers who might otherwise have considered making gifts of property to their issue,[v] whether outright or in trust, in order to take advantage of the current basic exclusion amount,[vi] may no longer feel comfortable with giving up control of such property[vii] or of the income it generates, at least not without receiving something in exchange in order to provide themselves some financial cushion.

Fortunately, today’s historically low interest rate environment[viii] favors certain planning techniques that may allow a taxpayer to at least “freeze” the value of their gross estate by shifting appreciation to their issue, while at the same time providing the taxpayer with a degree of economic security.

These estate planning strategies seek to take advantage of the low rates that are now prevalent by requiring the taxpayer-donor to act as a lender while their issue-beneficiary (or a trust for their benefit) acts as a borrower.

In concept, the taxpayer will transfer money to their beneficiary in the form of a loan – evidenced by a note that includes terms for its repayment to the taxpayer – the proceeds of which the beneficiary will use to acquire property that may currently be undervalued but which is reasonably expected to appreciate (and/or generate income) over time. Alternatively, the taxpayer may sell such property to a grantor trust[ix] for the benefit of their issue in exchange for a term note.

There are other variations on this approach; in each case, their success from a tax planning perspective depends upon the appreciation in value of the property that is acquired by the beneficiary (or trust) using the loan proceeds, or that is sold by the taxpayer to the grantor trust, at a rate that exceeds the AFR, or other statutorily prescribed rate derived from the AFR,[x] at which interest is paid to the taxpayer.

Intra-family Loan

The most straightforward of these interest-sensitive techniques – but not necessarily the simplest – is a loan of money from the taxpayer to one of their issue, or to a trust for the benefit of such issue.

Assuming the taxpayer charges interest at a rate that is at least equal to the AFR, the transfer of money (by itself) will not be treated as a gift for purposes of the federal gift tax.[xi]

However, in order for this strategy to be successful, the property in which the child or trust invests the loan proceeds has to generate an economic return in excess of the AFR.[xii] In that case, the value “shifted” to the borrower-issue will exceed the amount to be repaid to the lender-taxpayer.[xiii] Stated differently, the “spread” between the AFR and the actual return on the property may be viewed a tax-free gift to the taxpayer’s issue.[xiv]

As mentioned above, the repayment of the loan – i.e., the return of the money transferred by the taxpayer, plus interest – may be a key consideration in the taxpayer’s decision to make a loan rather than a gift to the child.

Of course, in order for the repayment of the taxpayer’s “loan” to be treated as such – i.e., as a nontaxable return of capital to the taxpayer, along with the taxable interest that was charged by the taxpayer in exchange for the use of the taxpayer’s money –   the initial transfer from the taxpayer to their issue has to be respected as a bona fide loan.

One taxpayer recently learned that it is no simple matter to structure an intra-family loan that will be respected as such by the IRS and the courts.[xv]

Loans or Advances of One’s Inheritance?

Mom had five children. She and the children were among the beneficiaries of a trust established by her deceased former spouse (the “Trust”).

Mom was determined to divide her assets among her children equally. Her practice was to maintain a written record of any amounts she advanced to each of them, and the “occasional repayments” for each child. On the basis of her original intent, and on the advice of her tax counsel, she treated the advances as loans.[xvi]

Every year, Mom forgave the “debt” account of each child[xvii] to the extent of the-then applicable federal gift tax exemption amount.[xviii] According to the Tax Court (see below), Mom’s practice “would have been noncontroversial” – provided the original transfers from Mom were, in fact, bona fide loans – but for the substantial amount Mom advanced to Son.

Son took over Dad’s business. After enjoying some early success, Son began to experience serious financial difficulties; eventually, the business fell behind on its bills. At that point, Son entered into an agreement with the Trust to use its property as security for bank loans to Son’s business.[xix] Within a year, Son failed to meet his obligations under the loan, and the Trust was ultimately held liable for the loan owed to the bank.

Mom was aware of Son’s business issues. Over the course of 22 years, Mom made annual transfers of varying amounts to or for Son’s benefit, which she treated as loans;[xx] in the aggregate, these exceeded $1 million.

Son did not repay any part of these advances to Mom, although he was gainfully employed throughout those years.

Mom’s Estate Plan

During these years, Mom established the Revocable Trust, under the original terms of which she specifically excluded Son from any distribution of her estate upon her death.

Mom subsequently amended the Revocable Trust such that it no longer explicitly excluded Son from any distribution, but provided a formula to account for the “loans” made to Son during Mom’s lifetime.

Among the other estate planning documents prepared for Mom at that time was a document captioned “Acknowledgment and Agreement Regarding Loans” (the “Acknowledgment”). The Acknowledgment was dated and signed by Son. The Acknowledgment recited that Son had “received, directly or indirectly, loans from [Mom],” and that he had “neither the assets, nor the earning capacity, to repay all, or any part, of the amount previously loaned, directly or indirectly, to” him by Mom.[xxi]

Furthermore, Son “acknowledge[d] and agree[d]” that, “irrespective of the uncollectability or unenforceability of the said loans, or any portions thereof, the entire amount” thereof, “plus an imputed amount of interest thereon, computed at the Applicable Federal Rate for short-term indebtedness [[xxii]] determined as of the end of each calendar year, shall be taken into account” by the Revocable Trust for purposes of dividing the trust’s assets among Mom’s children (including Son) upon her death.

In essence, the value of the Revocable Trust’s assets – after allowance for expenses, including estate tax – would be divided equally among Mom’s children; however, each child’s “preliminary” share would be reduced by an amount equal to that child’s outstanding loans, if any, plus the interest deemed to have accrued thereon; the amount of such reduction would be redistributed pro rata (equally) among the other children.

IRS Audit and Tax Court

Following Mom’s death, the fiduciary of her estate filed an estate tax return on IRS Form 706.[xxiii] Among the assets included on the return were the debts owing from Son to Mom, which were valued at zero.

The IRS examined Mom’s estate tax return, and issued a notice of deficiency[xxiv] in which it asserted that the estate had undervalued Son’s debt; it also added the interest accrued on the debts to Mom’s gross estate.

In the alternative, the IRS argued that the advances Mom made to Son over the years should have been treated as gifts and, thus, should have been added to the “adjusted taxable gifts” included in computing Mom’s estate tax liability.[xxv]

Mom’s estate petitioned the U.S. Tax Court to review and reverse the IRS’s determination.

At some point in the judicial process, the IRS conceded its primary position in the notice of deficiency, that the estate tax return undervalued the debts from Son. Therefore, the issue before the Court was whether Mom’s advances to Son were loans or gifts.[xxvi]

The Court began by reviewing the “traditional factors” used to decide whether an advance was a loan or a gift. Those factors, the Court explained, are as follows: (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 “debtor” had the ability to repay, (8) records maintained by the “creditor” and/or the “debtor” reflected the transaction as a loan, and (9) the manner in which the transaction was reported for Federal tax purposes was consistent with its status as a loan.

However, the Court added that these factors were not exclusive. Moreover, the Court explained, in the case of a family loan, “it is a longstanding principle that an actual expectation of repayment and an intent to enforce the debt are critical to sustaining the tax characterization of the transaction as a loan.”[xxvii]

In the present case, the Court continued, although Mom recorded the advances to Son as loans and kept track of interest, there were no loan agreements, there were no attempts to force repayment, and there was no collateral securing Son’s obligation to repay the loans.

The reasonable possibility of repayment, the Court commented, was an objective measure of a purported lender’s intent. In response to the estate’s assertion that, during her life, Mom considered these advances as loans, the Court stated that it could not reconcile the estate’s position with the deterioration of Son’s financial situation and the ultimate failure of Son’s business.

The Court observed that Mom may have expected Son’s business to do well, and may have been slow to lose that expectation. However, it was clear that Mom had realized Son was very unlikely to repay her loans when he executed the Acknowledgment and she contemporaneously amended the Revocable Trust to account for those loans in determining Son’s share of her estate at the time of her death.

At that point, according to the Court, the theretofore “loans” lost that characterization for tax purposes and became advances on Son’s inheritance from Mom.

Thus, the Court concluded the advances to Son were loans up to the time that Mom amended her Revocable Trust – in recognition of the fact that, given Son’s financial distress, the loans could not be repaid – following which the advances became gifts that should have been accounted for in determining Mom’s estate tax.


The Court was generous in finding that Mom’s advances were loans at any time they were outstanding, notwithstanding her initial confidence that Son would repay them.

Although the intent of the parties is a significant factor in determining whether they were creating a debt, there has to be a reasonable expectation of repayment, and that intent has to comport with the economic reality of creating a debtor-creditor relationship.

In this case, the arrangement between Mom and Son failed almost every traditional factor described by the Court, above; no note, no interest, no collateral, no payment, no demand for payment, no maturity date. On these facts, should Mom’s subjective belief in Son’s ability to pay have sufficed for purposes of treating the initial advances as loans? I would not have banked on that alone.

If a taxpayer is seriously contemplating a loan to their issue as an alternative to a gift, and if the parties believe that the investment to be made using the loan proceeds has a reasonable possibility of success (as discussed above), they should treat with one another as closely as possible as they would with an unrelated party.[xxviii]

For me, that means separate legal representation for the taxpayer and their issue, a written agreement to evidence the loan, a reasonable term of years that considers the taxpayer’s desire for the funds to be returned,[xxix] interest at the AFR payable at least annually,[xxx] no prepayment penalty,[xxxi] adequate security for the loan, reporting for tax purposes consistently with a debtor-creditor relationship, and consistent representations to others (for example, personal financial statements). In this way, the parties should be well-positioned to resist any claim by the IRS that the transfer of money was actually a taxable gift.

[i] With adverse consequences for the restaurants and other retail establishments that serviced them.

[ii] Reminiscent of emigres who, historically, flee their homes at the first sign of revolution?

[iii] Some may argue that this is to be expected in our two-party system. Others will say that this division is a good thing because the electorate will have a better idea of which party’s vision for the future of the country comports with their own. In response, I say, at what cost?

The most recent Gallup poll indicates that 75% of the public disapproves of the way Congress has handled its job. https://news.gallup.com/poll/1600/congress-public.aspx

[iv] See “Pentagon Leaders Worry Trump Will Drag Military Into Election,” by Jennifer Steinhauer and Helene Cooper, The New York Times (September 26, 2020).

“I wish it need not have happened in my time,” said Frodo.
“So do I,” said Gandalf, “and so do all who live to see such times. But that is not for them to decide. All we have to decide is what to do with the time that is given us.”

[v] For our purposes, their children or grandchildren (the “beneficiary”). https://www.taxlawforchb.com/2020/03/think-before-you-gift-but-dont-take-too-long/

[vi] $11.58 million. IRC Sec. 2010 and Sec. 2505.

[vii] Or they may be interested in scaling back their plans for gifting.

[viii] At the most recent meeting of the Federal Open Market Committee, the Federal Reserve committed itself to keeping short-term interest rates near zero percent for the foreseeable future. https://www.thebalance.com/fomc-meetings-schedule-and-statement-summaries-3305975 .

The long-term Applicable Federal Rate (“AFR”) under IRC Sec. 1274 for September 2020 is only 1%; for October, it will be 1.12%. Rev. Rul. 2020-20. This is well-below a fair market rate that would be charged by a commercial lender.

[ix] Rev. Rul. 85-13. Most readers are probably familiar with a grantor’s sale to a grantor trust – a nonevent for purposes of the income tax. https://www.taxlawforchb.com/2015/08/sale-to-idgts-the-death-of-the-grantor/ A variation on this is the SCIN. https://www.taxlawforchb.com/2015/09/scin-ing-the-tax-adviser-part-i-of-ii/ .

Then there is the grantor retained annuity trust, or GRAT, which is a trust created under IRC Sec. 2702 and the regulations thereunder. In form, the GRAT involves the sale of property by the grantor to a grantor trust in exchange for the right to be paid an annuity from the trust every year, for a specified number of years. When this term of years ends, the property in the trust will either remain in trust for the benefit of the grantor’s issue, or it may pass outright to the issue as the beneficiaries of the remainder interest. The amount of the gift arising from the transfer to the trust is equal to the excess of (i) the value of the property transferred, over (ii) the present value of the grantor’s annuity interest.

[x] IRC Sec. 7520.

[xi] IRC Sec. 7872.

[xii] In other words, it has to exceed the amount of principal plus AFR-interest that is to be returned to the taxpayer.

[xiii] Stated differently, the lower the rate charged, the more effective the loan will be.

[xiv] An added benefit: the interest paid by the child to the taxpayer remains within the “family unit” rather than being paid to an unrelated commercial lender.

[xv] Est. of Bolles v. Comm’r, T.C. Memo 2020-71.

[xvi] The Court did not mention whether (i) the “debts” – the Court used quotations marks – were evidenced by promissory notes, (ii) Mom and the borrower-child had agreed to repayment terms (for example, a maturity date), (iii) interest was paid (or was imputed for tax purposes), (iv) the debt was secured in any way, or (v) Mom or the child represented to third parties that her transfers to the child were loans.

[xvii] A creditor’s forgiveness of an amount owing from a debtor generally results in the accretion of value in the hands of the debtor. For that reason, the debtor is treated as having realized income in the form of the debt cancelation. IRC Sec. 61(a)(11).

However, the Code also provides, for various policy reasons, that the cancelation of debt in certain circumstances should not be treated as a taxable event. For example, where the debtor is insolvent, the debt cancelation is not included in the debtor’s gross income to the extent of the debtor’s insolvency immediately before the cancelation; after all, to that extent, the debtor has not realized any accretion in value. IRC Sec. 108(a)(1)(B) and Sec. 108(a)(3).

Interestingly, Sec. 108 does not expressly refer to “gift” transfers of a debtor’s indebtedness. That said, under IRC Sec. 102(a)(1), an individual’s gross income does not include the value of any property acquired by gift.

[xviii] Currently at $15,000 per year. IRC Sec. 2503.

To illustrate how the annual gift exclusion works: during 2020, I can choose to make a gift of $15,000 to every person in the Manhattan phone book without incurring any gift tax liability and without consuming any part of my unified lifetime/testamentary exemption amount.

[xix] The agreement also reflected that Son’s business owed Trust back rent. It appears that Trust owned the real property out of which the business operated.

[xx] Mom directly transferred money to Son, deposited money into accounts to which Son had access, made payments on loans taken out by Son, and issued a letter to a lending institution allowing Son’s business to withdraw funds to pay interest on a loan.

[xxi] The Court’s opinion is silent as to whether Mom claimed a bad debt deduction under IRC Sec. 166 with respect to her advances to Son. Unlikely.

[xxii] Which may indicate that these were demand loans, without repayment terms or a maturity date. IRC Sec. 7872.

[xxiii] United States Estate (and Generation-Skipping Transfer) Tax Return.

[xxiv] IRC Sec. 6212.

[xxv] Under IRC Sec. 2001(b).

[xxvi] The estate argued that, under Tax Court Rule 142, the IRS had the burden of proof on the gift issue. Although the Court admitted that the estate’s position had some merit, the Court also stated it did not need to resolve the issue because the evidence in the case permitted a resolution on the record of trial.

[xxvii] The IRS and the courts have long recognized that transactions between members of a family and the family-controlled business – as is also the case for intra-family transactions, generally – are subject to rigid scrutiny, and are particularly susceptible to a finding that a transfer of funds by the business was intended as something other than a loan. https://www.taxlawforchb.com/2020/08/transfer-of-funds-between-related-entities-indebtedness-or-something-else/#_edn15

[xxviii] If the investment is something that the taxpayer, themselves, would not consider, then the taxpayer shouldn’t make the loan, at least under the assumption made herein that the taxpayer is not comfortable with giving up control of their property without receiving consideration in exchange therefor.

[xxix] To lock in the favorable AFR as the interest rate. The rate on a demand loan fluctuates month-to-month, though the blended rate (published twice a year) may be utilized. What’s more, what third party makes a demand loan, at least without valuable collateral?

[xxx] No third party would accrue the interest until the end of the term. In any case, we’re talking about very low rates here. If the borrower cannot handle current interest payments at this AFR, the taxpayer should probably forget about making the loan.

What’s more, we’re assuming herein that the taxpayer wants to be compensated for the use of their money.

[xxxi] Which effectively allows the borrower to turn the loan into a demand loan.