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).
Subscribe to Kiplinger’s Personal Finance
Be a smarter, better informed investor.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
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.
This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
Jeffrey M. Verdon, Esq. is the lead asset protection and tax partner at the national full-service law firm of Falcon Rappaport & Berkman. With more than 30 years of experience in designing and implementing integrated estate planning and asset protection structures, Mr. Verdon serves affluent families and successful business owners in solving their most complex and vexing estate tax, income tax, and asset protection goals and objectives. Over the past four years, he has contributed 25 articles to the Kiplinger Building Wealth online platform.
Is Chevron Stock Set for a Rebound?
Chevron stock received its second analyst upgrade in as many days, boosting hopes for a recovery in the lagging energy major.
By Dan Burrows • Published
Where Americans Most Use Deals and Coupons
While you may not be an extreme couponer, you’ve probably had deals on your radar. Here's where shoppers practice the most savings strategies.
By Erin Bendig • Published
Retirement Planning with Life Insurance
An indexed universal life insurance policy can help you with tax mitigation and extra retirement income in addition to death benefits for your beneficiaries.
By Mike Decker • Published
Which Retirement Accounts Should You Withdraw From First?
Here’s a standard order for when you should tap which account when you’re in retirement.
By Evan T. Beach, CFP®, AWMA® • Published
Nervous About the Markets and Economy? Consider History
To put things in perspective, focus on what you can control and remember that the ups and downs of the markets and economy can be cyclical.
By Erin Wood, CFP®, CRPC®, FBSⓇ • Published
Expecting a Recession? Seven Steps to Help You Power Through
Instead of panicking, consider opportunities to add flexibility and resilience to your financial position. These steps can help you enter a potential recession from a position of strength.
By Christian Mitchell • Published
What Is Indexed Universal Life Insurance and How Does It Work?
This permanent life insurance provides a death benefit to your beneficiaries but also offers a cash-value component that can grow over time.
By Mike Decker • Published
How to Fail as a Leader
The authors of the new book 'Real-Time Leadership' outline the traits of effective leaders (kindness is key) and what will ensure a leader’s failure.
By H. Dennis Beaver, Esq. • Published
Are You Worried About Running Out of Money in Retirement?
Planning that integrates income annuities can help alleviate the No. 1 fear of retirees, even in worst-case investment scenarios and when living way beyond your life expectancy.
By Jerry Golden, Investment Adviser Representative • Published
Three Ways Charitable Organizations Can Boost Public Trust
Silicon Valley Bank’s collapse adds to distrust in institutions, and that’s affecting nonprofits and grantmakers. Fresh expressions of transparency can show that the nonprofit sector is different.
By Stephen Kump • Published