Recent Case Evaluates Whether Mom’s Transfer To Son Was A Loan Or Gift

A very common family transaction is the transfer of funds to a child or other heir. How that ubiquitous matter is handled is key to the tax and legal consequences. A recent case held that the transfer was a loan, not a gift, which was a positive tax result for the taxpayer. Estate of Barbara Galli et al. v. Comr.., T.C., No. 7003-20. The Galli Court referred to a seminal loan characterization case in its analysis: Miller v. Commissioner, 71 T.C.M. (CCH) 1674 (1996). But the lessons and planning opportunities from the Galli case for families go well beyond the facts in this case, and those will be explored as well.

Consequences to Child/Borrower and Parent/Lender Are Significant

If the transaction is treated as a loan the child/borrower will have to report the debt on his or her personal balance sheet. That could, for example, effect the child’s ability to qualify for a mortgage on the purchase of a house. If the transfer of funds is treated as a gift, then the cash is owned by the child. Should the child be divorced or sued those funds will be reachable by the ex-spouse or creditors. That could be a devastating consequence.

For the parent (or other benefactor) if the transaction is treated as a loan, the value remains an asset of theirs subject to the reach of their divorce or creditors. That asset may have an impact on qualifying for Medicaid or other governmental programs. If the parent’s transfer is characterized as a gift and is sufficiently large a gift tax could be triggered. However, with the current gift tax exemption at almost $14 million few people would have to worry about that aspect. If the transfer is a loan there may also be income tax consequences in that interest must be charged which will trigger income tax to the parent/lender and likely won’t provide an income tax deduction to the child unless the restrictive interest deduction rules are complied with.

Lots of Ways to Skin the Loan/Gift Cat

The brief description above makes it very clear that whether your transfer of funds to a child or other heir should be structured as a gift or a loan has profound legal, tax and financial implications to both of you. Which approach is better really requires some analysis of the current situation and long-term consequences. There are also more options to evaluate then merely a loan or gift. For example, say your child needs $500,000 to buy their first home. Do you loan them the money or gift them the money? Consider all the possible options, not just a simple loan or gift.

• Loan money.
• Gift the money.
• Buy the house in your name and let the child use it.
• Buy the house in your name and rent it to the child.
• Have existing family trusts (and/or LLCs) buy the house. As one example, if you buy the house and let the child use it rent free the value of that is a gift. However, if a family trust that the child is a beneficiary of instead of you buying the house, the trust can give a beneficiary the right to free use of a trust asset without any gift or other tax consequences).
• Guarantee a loan the child takes and have the child buy the house with bank financing instead of your funds. That may help the child gain financial maturity, obtain a home mortgage interest deduction, etc.
• Any combination or variation of the above might be feasible.

The Many Faces of a “Loan”

The discussion above just spoke of a generic “loan.” But loan transactions and note documents, just like ice cream, can come in many flavors. Understanding that there are many options and variations may help you tailor whatever you do to better accomplish your goals. Sure, in many cases vanilla ice cream works. So might a simple note form and loan with interest and a set maturity date might suffice, but not always. Consider that there are many types of loans with many types of terms.

• Plain vanilla loan.
• Balloon note that matures at a fixed date with all interest and principal being paid on maturity.
• A secured loan (e.g. where a lien on real estate, or a mortgage) protects the lender.
• An unsecured loan.
• A loan could be made with a fixed term or payable only when the lender demands repayment.
• A loan could be a revolving loan so that a single legal document may encompass future advances as well.
• Loans can be participating. For example, you loan your son’s business money to expand. Say the fair arm’s length interest rate for such a transaction is 6.5%. Instead, you make the loan for 5% but with an interest kicker of 3% of profits until the loan is repaid. There are a myriad of variations on this type of arrangement.
• The loan could be secured by life insurance and structure to be what the tax laws refer to as a “split-dollar” loan. This is a specialized type of loan that can have valuable estate or business planning implications.
• The loan could be a self-cancelling installment note (“SCIN”) which would have a higher interest or principal payment to compensate the lender for the risk that if the lender dies before the loan matures the loan would be cancelled.
• Another type of note is a so-called “King” note. This is a note whose face amount is adjusted if the value of an asset involved in the transaction is increased by the IRS on audit. For example, you sell a $10 million family business to a family trust for a $10 million note. The IRS on audit succeeds in proving that the value of the business interest sold was $20 million, not the $10 million you thought. The amount due from the trust to you under the note is increased from the original $10 million to the $20 million value to avoid a gift by you to the trust.

Just consider that there are lots of variations and if you ask an attorney or AI for a “note” you might get a note but more thought should be given to what type of note you use in each loan transaction.

If You Have Many Intra-Family Loans

While the following is not relevant to the Galli case, it comes up frequently in family planning and warrants comment since this article is taking a broader view of loan planning generally. When there are multiple family loans outstanding at the same time, you the big picture of those loans should also be considered. Apart from addressing the details of each loan, as discussed in detail below, what’s the big picture of all loans? For example, if your granddaughter or niece have three loans outstanding, why are there three separate loans? Should they be consolidated into one loan? Have circumstances changed? For example, you’re helping your niece by a condo. You made one loan to her for that purpose. But then you loaned here more money for renovations. Six months later you loaned her further funds for furniture and decorating. While she may have had the intent and wherewithal to repay the first loan, do those same conclusions follow for the second loan? What about the third loan? When family trusts, entities, businesses are involved in planning the number of loans can easily multiply with a family business loaning a family member money, one trust loaning another trust or business money, and so on. Schedule out all the loans and review the big picture. Are there other better ways to accomplish your goals without making loans? Are there so many loans that the IRS, a creditor, or even a minority equity owner, have support to argue that the loans are either inappropriate or should be treated as something else? For example, was the loan made by a family corporation in lieu of paying a dividend which would be taxable? Might a loan from an S corporation really be a disguised second class of stock which is prohibited? If the IRS succeeded in such a challenge the corporation’s tax status could be adversely affected.

Plan Don’t Just Get a Form

The key take home point, which is a point missed in many family and personal transactions, is that there are often many permutations of a plan. Start with your goals. Evaluate various available options and all of their consequences (tax, legal, financial, insurance, etc.). Don’t only view options from a simplistic single consequence lens. Simplicity (“I’ll just give the kid the money.”) is often not the best result. Starting with simplicity as your goal or focus will almost assure a lousy result. Instead start with your real goals and objectives (“I want the kid to learn financial responsibility.”) and evaluate each option from that perspective. But the reality is most family transactions are not handled well as too many people start with an answer (“I need a loan document.”) and instead of pursuing a thoughtful plan, seek out a document. Whether online or from an attorney, asking for a document may just get you a document. But which one? Should it be a gift letter, a loan document (and which type?), a deed, a lease or some combination?

Recent Court Case Weighs In On This Common Family Transaction

So, whether a transfer of cash is to be treated as a loan or gift could have significant impact on both the transferor parent and the transferee child. Planning, after evaluating which approach is really preferred, and paying attention to details, is important to support the desired result. A recent court case evaluated a typical family “loan” transaction to determine if it was a loan or gift. While the context of this case was gift and estate tax, the lessons are valuable to all families regardless of whether the gift and estate tax are a concern. Also, as with all such cases, there are lots of practical lessons to learn that can help others better structure their transaction.

Issue in this Tax Case

The main issue in this motion is the classification of a transaction between Stephen and his mom back in 2013, in which she transferred $2.3 million to him. They both signed a simple note calling it a loan. The document is dated February 25, 2013. The Gallis treated this as a loan, not a gift, and therefore never filed a gift-tax return that reported it. So, what was it? The Court ultimately found that the advance was in fact a loan, but as said above, there is much more to learn from evaluating the case in more detail.

Facts of the Case With Commentary

• Age. “At the time of the loan mom was 79 years old.” Comment: If a loan is made for more than the lender’s life expectancy the IRS has argued on audit that the loan should be recharacterized. While there would theoretically seem to be no issue with a loan of any duration, taxpayers might consider keeping the loan term somewhat less than life expectancy.
• Note Document. “The terms of the loan were set forth in a note that provided for a 9-year term and interest at an alleged applicable federal rate of 1.01%.” Comment: having a written signed document evidencing the loan is one of the foundational steps to having a transaction respected as a loan. Also, consider whether using the minimum required interest rate under the tax laws to avoid imputation of interest income is really enough. In some cases that should in fact avoid the imputation of interest or the finding of a gift, but in other cases it is not clear that using this minimum tax-based interest rate will suffice as it may be lower than an arm’s-length rate an unrelated third party might require.
• Interest Rate, Repayment. “The note provided for annual payments of interest, with repayment of the principal due at the end of the term.” Comment: Some loans are made to be repaid on demand, essentially whenever the lender calls the loan (demands repayment). It is probably preferable to have a fixed term of years and require the loan be repaid at the end of that term. Interest should be required to make the transaction have the appearance of being a real loan. While loans can be made without interest that might trigger the imputation of interest under the tax rules. That can create complications as well as tax whipsaw where the lender has to report the interest as income on her return but the borrower may not qualify for an income tax deduction.
• Interest Actually Paid; Respect Formalities. “The borrower made annual payments of interest as required during February of 2014, 2015 and 2016.” Later the Court stated: “Stephen, by contrast, submitted a copy of his mom’s bank record showing a transfer of $2.3 million, the note they both signed, his own bank records that show he paid interest to his mom each year, and even his mom’s income-tax returns that show she reported it as interest income.” The folks in the Galli case played by the rules and did much of what they should have done. That is often not the situation. Whatever terms are contained in the loan document, the parties (e.g., parent as lender and child as borrower) should respect those terms. Having the real (called “arm’s length”) terms in the note but ignoring them will be very detrimental to trying to support the characterization of the transfer as a loan. This is unfortunately too common. Families need to address the formalities of all transactions. And that advice applies not only to loans, but trust administration, entity formalities, and more. Creditors, ex-spouses, the IRS, state tax authorities, etc. commonly pursue the lack of adherence to formalities as a primary avenue to attack a transaction. After all the logic goes, if you yourself did not respect the formalities of what you did, why should they be required to. Calendar interest and principal payments as required under the terms of the loan. Calendar the maturity date of the loan. Make the payments as required.
• Security, Enforceability. “The loan was unsecured and the note lacked provisions necessary to create a legally enforceable right to repayment reasonably comparable to the loans made between unrelated persons in the commercial marketplace.” Comment: The litmus test for intra-family transactions is whether unrelated third parties would have done the same thing and accepted similar terms. That is often referred to as “arm’s-length” as noted above. It is not clear from the case what provisions were missing that may have made the loan not “legally enforceable.” However, a general take home lesson of this is not all forms are created equally. Getting an AI generated form, an inexpensive form from an online legal service, and yes, even a document prepared by an attorney, is never a guarantee that the terms of the note will pass muster. Review the note, read the terms, consider whether unrelated people would sign a similar document. Finally, the Court noted that the loan was unsecured. That alone is not fatal to maintaining loan status for the payment but it is a factor to consider. Unrelated parties do lend without security (e.g., a mortgage) but if they did there would be a business reason for the loan (e.g., a manufacturer extending credit to a customer), documented financial stability suggesting that the borrower has the wherewithal to repay the loan, or perhaps a higher interest rate to justify the additional risk that the lack of security may create.
• Ability and Intent to Repay. “It has not been shown that the borrower had the ability or intent to repay the loan. It has not been shown that the decedent had the intent to create a legally enforceable loan, or that she expected repayment.” Comment: There are really two separate factors noted by the court and both can be important. If the purported borrower doesn’t have the ability to repay, that is a negative factor towards supporting loan characterization. If, however, the borrower is a young adult child with bright future financial prospects perhaps that situation will change offsetting the negative implication. Not having any intent that the transfer of cash be repaid may be fatal to trying to characterize the payment as a loan. After all, the essence of a loan is that the funds will be repaid. Even worse, and it is common, emails between family members saying “Don’t worry son, you don’t have to repay the money” could torpedo the ability to characterize the transfer as a loan. Be very mindful of what is said, written or emailed as the communication may be saved and discoverable. Better, confirm that the transaction is a loan, treat it as a loan (e.g. on both parties’ financial statements and tax returns) and actually make interest and if possible some principal payments.
• Gift Tax Return. “The decedent did not file a gift tax return relating to the loan.” Comment: There is no requirement to file a gift tax return to report a transfer as a loan a loan is not a gift. But the lesson from this is that it may be strategically more prudent to file a gift tax return. If you make a gift of any amount over the annual gift tax exclusion, in 2025 that would be $19,001, that triggers the requirement to file a gift tax return. Then, report the loan as a non-gift transaction. You should also attach a copy of the signed note as an exhibit to the gift tax return. This step will run (toll) the time period during which the IRS can audit the transaction (statute of limitations). Because of the cost of filing a gift tax return this will only be practical when larger dollar amounts are involved. And for larger transactions filing a gift tax return may be an inexpensive insurance policy to avoid a future audit.
• Estate Tax Return. On March 7, 2016, the decedent died, leaving a taxable estate that included the loan repayment obligation reflected by the note. Comment: This was a positive factor. The lender’s estate tax return post-death reflected as an asset the unrepaid loan. That was appropriate. If the estate were too small to trigger a requirement to file, as it will be for many people, then that reporting is not necessary. Many estates will file an estate tax return even if there is no estate tax in order to secure the estate tax exemption of the deceased spouse (DSUE). In such cases the note should also be listed as an asset of the estate, although special valuation rules might apply if filing solely to secure the DSUE. The Court had an interesting discussion of how the note should be valued in the estate. There seems to be a disconnect with the requirements to use a specified interest rate on a loan made to avoid gift characterization, but then when the loan is valued in an estate at its “fair market value” a discount may be arguable. But this important discussion is not pertinent to the narrower topic of this article about preserving characterization of a transfer of money as a loan.

Using Federal Mandated Interest Rate Suffices to Avoid a Gift

In addition to the Court finding that the transfer of funds by mom to son was a loan and not a gift, the Court also confirmed what most tax advisers have believed, that using the minimum required federal interest rate on a family loan will suffice to avoid any imputation of a gift. This mandated federal interest rate is called the applicable federal rate (“AFR”) and is provided for under Code Section 7872. “The IRS publishes these throughout the year and they are important in interest computations for a variety of tax-law purposes including, as here, the distinction between loans with below-market interest rates that trigger gift-tax rules and those that do not.”

The Court found: “Because his mom’s loan to him charged the applicable federal rate it is, to use the jargon of the Code, not a “below-market loan to which section applies.” See IRC §7872(c). That might leave open the question of whether to recharacterize a loan as a partial gift if it carries an interest rate below market but equal to or above the applicable federal rate. But we rejected this argument many years ago in Frazee v. Commissioner, 98 T.C. 554, 588 (1992), where we held that “[t]he coverage of section 7872 clearly goes beyond Dickman to provide comprehensive treatment of below-market loans for income and gift tax purposes.”

We reiterated the point later in that opinion by concluding that “Congress indicated that virtually all gift transactions involving the transfer of money or property would be valued using the current applicable Federal rate. . . . Congress displaced the traditional fair market methodology of valuation of below-market loans by substituting a discounting methodology.” Id. at 589.

Conclusion

Family loans have been and will remain a very common estate planning transaction. In Galli the note was respected and using the mandated federal interest rate on a family loan will avoid any gift tax consequences or income tax imputation. That is all good for taxpayers. But looking at the lessons of this case broadly, there are many important lessons to consider in how family and other related party loan and “loan-like” transactions are planned, documented and implemented. Hopefully, any misconception that loans are all the same, or that the simple answer is best, or that once the loan document is signed that nothing else need be done, are clear.