It is very common for parents to provide funds to their children over their lifetime, but are these transfers gifts or loans? A recent ruling in the Tax Court, Estate of Bolles v. Commissioner, T.C. Memo. 2020-71, 119 T.C.M. (CCH) 1502 (June 1, 2020), highlights the importance in estate planning of differentiating between loans and gifts.
Mary Bolles was a loving mother of five children whom she tried to treat equally. Her practice was to keep a record of her advances to and the occasional repayments from each child. Based on her intent and the advice of tax counsel, she treated the advances as loans. She forgave the “debt” account of each child every year to the extent of the annual gift tax exclusion amount. According to the Tax Court, her practice would have been noncontroversial had she not advanced substantial funds to one son, Peter.
When Peter ran into financial difficulties with his architectural business, Mary supported him and between 1985 and 2007 she transferred $1,063,333 to Peter or for his benefit.
In 1989 Mary established the Mary Piper Bolles Revocable Trust, which excluded Peter from any distribution of her estate upon her death. Mary later amended the trust–Peter was no longer entirely excluded but his distribution was tied to a formula to account for loans made to him by Mary. In 1995 Peter signed an acknowledgment that he had received loans from Mary and would not be able to repay her.
When Mary died in 2010, the IRS assessed her estate with a deficiency of $1.15 million in estate taxes, taking the position that the entire $1,063,333 transferred to Peter was a loan and included in her taxable estate. The IRS argued that the loan had accrued interest in the amount of $1.165 million and that a total of $2.23 million should be added to the value of Mary’s estate. The estate argued that the $1,063,333 in transfers were prior taxable gifts, and therefore while those gifts would be added to the tax base there should be no accrued interest added to the value of the estate.
Traditionally courts consider the following factors in determining whether an advance is a gift or a loan: (1) whether there was a promissory note or other evidence of indebtedness, (2) whether interest was charged, (3) whether there was security or collateral, (4) whether there was a fixed maturity date, (5) whether a demand for repayment was made, (6) whether actual repayment was made, (7) whether the transferee had the ability to repay, (8) whether records maintained by the transferor and/or the transferee reflect the transaction as a loan, and (9) the manner in which the transaction was reported for Federal tax purposes is consistent with a loan.
In Mary’s case, the Tax Court found that through 1989 the advances to Peter constituted loans, but from 1990 on, the advances would be considered gifts. While Mary had always recorded the advances to Peter and kept track of interest, there were no loan agreements, collateral, nor requests for repayment. The Court noted that Mary initially had an expectation of repayment, but eventually it became clear to her that Peter’s business would not be successful and that he would not have the means to repay her. The Court noted that the “reasonable possibility of repayment is an objective measure of Mary’s intent.” The evidence of Mary’s intent was key to the characterization of the advances as gifts. While Mary could have chosen to forgive the loans, she instead appeared to have accepted that the advances to Peter from 1990 forward would not be repaid. The Court noted that in the case of a family loan, an actual expectation of repayment and an intent to enforce the debt are critical to sustaining the characterization of the transaction as a loan.
The lesson here is that while family loans can be great estate planning tools, the recordkeeping, actions, and intent of the parties are vital in determining whether an advance will be considered a loan or a gift in the eyes of the IRS, with serious financial consequences both during life and at death if the distinction is not clearly made.
Miller v. Commissioner, T.C. Memo 1996-3, aff’d, 113 F.3d 1241 (9th Cir. 1997).