It is not uncommon for family members to lend a helping hand to one another through intrafamily loans. While loans can benefit family borrowers who may not qualify for a traditional loan or who need flexible payment arrangements, loans can also be a strategic wealth planning tool for those who want to pass wealth down to younger generations without incurring transfer tax. Unsurprisingly, however, the IRS intensely scrutinizes intrafamily loans and often presumes they are gifts. If not crafted carefully, intrafamily loans may trigger unwanted and significant tax consequences.
Intrafamily loans can help a family member, trust or family-owned entity purchase real estate, invest in a new business venture or pay off debt. Intrafamily loans can also be used strategically to achieve the transfer of appreciation and cash flow from the loaned asset to the borrower on a tax free or tax minimal basis.
Keep in mind that formality is key. In Estate of Galli v. Commissioner, T.C., No. 7003-20 and 7005-20, Barbara Galli loaned $2.3 million to her son, Stephen Galli. Upon reviewing Barbara’s federal estate tax return, the IRS issued a notice of deficiency for nonpayment of gift tax and underpayment of estate tax, arguing that the intended loan to Stephen was instead a gift because the loan was informally executed and unenforceable. The United States Tax Court disagreed and determined that Barbara and Stephen had executed a written promissory note, she charged interest at a mid-term applicable federal rate, he routinely paid interest due and she properly reported the payments on her income tax returns. Together, those factors demonstrated to the Tax Court that the transfer was a legitimate loan and not a gift.
Prior to the Galli ruling, the Tax Court set forth nine factors to contrast a bona fide debt from a gift in Miller v. Commissioner, T.C. Memo 1996-3, aff’d, 113 F.3d 1241 (9th Cir. 1997). The factors include:
- The existence of a promissory note or evidence of indebtedness.
- Interest charged at equal to or greater than the applicable federal rate.
- The existence of security or collateral for the loan.
- A fixed maturity date.
- A demand for repayment.
- Actual repayment.
- The borrower’s ability to repay the note.
- Maintenance of records documenting the loan.
- Proper reporting of the loan for income tax purposes.
Careful compliance with the factors established in Miller is the best way to ensure a loan between family members and family entities will not be reclassified as a gift. Additionally, you should consult with a trusted estate planning or tax advisor to evaluate not only the loan terms, but also before forgiving or refinancing an existing intrafamily loan. Failure to do so invites the IRS to challenge the legitimacy of a loan and can result in unwanted gift, estate and income tax consequences.
