personal finance

Gifts vs. Loans: Don’t Be Generous to a Fault

What most of you would think of as a “loan to a family member” the IRS may consider a “gift” instead. And that can be a very expensive difference of opinion.

As parents, we often want to help our adult children who need a financial boost. And many times, this assistance comes in the form of a loan. Loans are an effective and common way for parents to foster a child’s independence, encourage responsibility and signal their confidence that their child can succeed on their own.

Moreover, with the current historically low interest rates, parents have less interest income to report and children can pay less interest than they would have if they borrowed funds from a bank. Unlike gifts, loans do not utilize any of your lifetime gift tax exemption, which currently stands at a record-high $11.58 million per person (indexed for inflation).

The Case of Mary Bolles

While intra-family loans are important tools that can be used to transfer wealth to the next generation, most parents are unaware that their actions and expectations with respect to repayment of the loan can recharacterize the “loan” to a taxable “gift,” resulting in unintended gift tax consequences. This is exactly what happened to Mary Bolles in the recent case of Estate of Mary P. Bolles v. Comm’r, T.C. Memo. 2020-71 (June 1, 2020). 

Mary, a mother of five, made numerous loans to each of her children and kept meticulous records of each loan and any repayments. Between 1985 and 2007 Mary loaned her son Peter approximately $1.06 million to support his business ventures, even when it eventually became clear he would not be able to make any more payments on the loans. Moreover, none of the loans to Peter was ever formally documented, and Mary never attempted to enforce the collection of any of these loans.  

In late 1989, Mary created a revocable living trust, which specifically excluded Peter from any distribution of her estate upon her death. Though she later amended her trust to no longer exclude him, she included a formula to account for the “loans” Peter received in making distributions to her children. After her passing, the IRS took the position that the entire amount of the loans, plus accrued interest, was part of her estate. They assessed the estate with a tax deficiency of $1.15 million.  The estate took the opposite position, claiming that the entire amount was a gift. 

What the Court Decided

In its analysis, the court examined certain factors to be considered in deciding whether the advances were loans versus gifts.  Noting that the determination depends not only on how the loan was structured and documented, the court emphasized that in the case of an intra-family loan, a critical consideration is whether there was an actual expectation of repayment and intent to enforce the debt.

The court ultimately “split the baby,” holding that any advances prior to 1990 were in, fact loans (totaling over $425,000), since the evidence suggested that Mary reasonably expected that he would repay the loans …  up until he was disinherited from her trust in late 1989. The court deemed the funds given to Peter after he was disinherited — from 1990 onward — as gifts.

What Anyone Considering a Loan Should Remember

The takeaway from this case is that if you are thinking about taking advantage of the elevated gift tax exemption before it sunsets, it would be prudent to review any outstanding family loan transactions. You should determine the extent to which such loans may have been transmuted into gifts over the years that could adversely impact the amount of your remaining available exemption.  The safest way to do this would be to consult a tax expert who can help you safely navigate these complex rules. To be safe, follow these simple steps:

  • Document the loan transaction between the lender and borrower.
  • Charge interest based on the government rates (AFR) published monthly.
  • Make sure the borrower will have sufficient net worth to likely repay the loan.  Request and retain a copy of the borrower’s financial statement.
  • If the loan calls for period payments, make sure the payments are timely made.
  • Report the interest income you receive from the borrower on your income tax return.

Because actions may speak louder than words where family is involved, it is important to remember that you and your family should continue to treat any such loans as third-party loans in order to avoid any unintended estate tax consequences down the road.  Intra-family loans are a beneficial way to transfer wealth from one generation to the next, considering the very low interest rate environment.  Just make sure you do the transaction properly to avoid any issues down the road.

About the Author

Jeffrey M. Verdon, Esq.

Managing Partner, Jeffrey M. Verdon Law Group, LLP

Jeffrey M. Verdon, Esq. is the managing partner of the Jeffrey M. Verdon Law Group, LLP, a Trusts & Estates boutique law firm located in Newport Beach, Calif. With more than 30 years of experience in designing and implementing comprehensive estate planning and asset protection structures, the law firm serves affluent families and successful business owners in solving their most complex and vexing estate tax, income tax, and asset protection goals and objectives.

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