The Ninth Circuit Court of Appeals recently affirmed a Tax Court opinion dealing with the effect of lifetime transfers by a mother (Mary) to her son (Peter).[1] At issue was the nature of those transfers. On the one hand, Mary Bolles and her estate argued that the transfers constituted loans from Mary to Peter. On the other hand, the IRS argued that the transfers were actually lifetime gifts from Mary to Peter. Ultimately, the Tax Court, affirmed by the Ninth Circuit, did not agree with either side’s all-or-nothing analysis. Rather, the courts determined some of the transfers to be valid loans while others were gifts.
We have written before about the need to properly document purported loans.[2] This case is yet another example of the need to properly understand the nature of bona fide debt for tax purposes and document the intended transaction to support that treatment. Here, given the circumstances, it is not clear whether Mary’s advances would be treated as loans even if the transactions been more completely documented. However, her estate certainly would have been in a better litigating position had that been done.
Facts
The facts of the case are fairly straightforward. Mary Bolles had five children. Through the years, she advanced funds to her children and documented those advances as loans. Mary accrued interest on the advances and documented any repayments, typically forgiving the debts each year based on the gift tax annual exclusion.[3] From 1985 through 2007, Mary advanced over $1 million to Peter.
Relevant to the outcome is that Peter was an architect who took over his father’s practice in the early 1970’s. By the mid-1980’s, Peter was not current on the practice’s debts. In 1983, a trust established by Peter’s father pledged $600,000 as security for a business loan. Within a year, the trust was held liable for that debt. In 1989, Mary removed Peter as a beneficiary of her revocable trust when all children had previously been treated equally. Importantly, by this time Peter had ceased any of the partial payments he had been making to repay his mother’s loans. Also, at this time, Peter signed a document acknowledging that “he has neither the assets, nor the earning capacity” to make any repayments.
Even though Mary personally documented the advances to Peter as loans and accrued interests, no promissory notes were issued and no collateral was offered by Peter as security. Then, after the 1989 modification to Mary’s estate plan, she later made an additional modification to reduce Peter’s share of her estate by her advances with interest. The court found that advances before 1989 constituted valid loans. However, all advances after 1989, once it was clear that Peter would be unable to repay the advances, were classified as lifetime gifts. This resulted in an estate tax deficiency of $1,152,356.
Discussion
Although there was some debate about the value of Peter’s purported indebtedness to Mary’s estate, the IRS conceded its position as to that issue. Rather, the IRS’ argument focused on the characterization of the advances as lifetime gifts by Mary to Peter.
As a threshold matter, intrafamily transactions are presumed to be gifts, requiring a bona fide creditor-debtor relationship to overcome that presumption.[4] To show a bona fide creditor-debtor relationship, there must be “a real expectation of repayment and intent to enforce the collection of the indebtedness.”[5] In analyzing the proper treatment of the relevant advances, the court noted that both parties relied on the same factors:
- there was a promissory note or other evidence of indebtedness;
- interest was charged;
- there was security or collateral;
- there was a fixed maturity date;
- a demand for repayment was made;
- actual repayment was made;
- the transferee had the ability to repay;
- records maintained by the transferor and/or the transferee reflect the transaction as a loan; and
- the manner in which the transaction was reported for Federal tax purposes is consistent with a loan.[6]
The court noted that the factors above are not exclusive. While Mary maintained records reflecting the transactions as loans accruing interest, the court found there could be no loan once there was no reasonable possibility of repayment. This was clear by 1989 as reflected in the facts. The court allowed advances to be treated as loans prior to that date, even though there was no loan agreement or attempts to force repayment, because the circumstances indicated a bona fide creditor-debtor relationship.
Conclusion
Intrafamily and other related party transfers will typically be presumed not to constitute debts. In that context, when a transfer is intended to be treated as debt, it is important to expect IRS scrutiny. Objective facts, rather than purported intent, will be used to analyze the true nature of the transfer.[7] Merely “booking” a transfer as a loan will not be enough. In this context, it is critically important in securing the intended tax treatment that the factors described above (and other variables) substantiate the existence of a bona fide creditor-debtor relationship and that there be a real expectation of repayment. Further, while the Tax Court did not necessarily find fault in Mary’s annual forgiveness of the debts equal to her gift tax annual exclusion amount, there should be no prearranged plan or expectation that the purported loan will be forgiven.
Ultimately, given Peter’s financial troubles that were apparent by 1989, there may have been nothing Mary and Peter could have done to substantiate the advances as loans. However, more generally, documenting loans with signed promissory notes, secured by reasonable collateral, with payments being made by a borrower who has the wherewithal to render payment is an important part of establishing the economic realities of a valid loan transactions. Many individuals do not feel the need to go to these lengths in intrafamily transactions or with their related legal entities. However, this case and many others illustrate the importance to taking these steps in obtaining the intended tax treatment. The stakes can be substantial and have consequences in a number of situations.[8]
[1] Estate of Bolles v. Commissioner, 2024 WL 1364177 (9th Cir. Apr. 1, 2024); Estate of Bolles, T.C. Memo 2020-71.
[2] Edmondson, Gray, “Moore: What is a Bona Fide Debt,” Aug. 29, 2019, https://esapllc.com/moore-debt2019/; Allen, Charles, “Lessons to be Learned in Company Loans to Family Members,” Aug. 26, 2020, https://esapllc.com/vhc-2020/.
[3] Note that the Tax Court opinion indicated this practice to be “noncontroversial.” However, in Rev. Rul. 77-299, the IRS ruled that a prearranged plan to forgive debts, then the transaction will not be respected as constituting bona fide debt.
[4] Miller, T.C. Memo 1996-3.
[5] Estate of Van Anda, 12 T.C. 1158, 1162 (1949).
[6] Miller, T.C. Memo 1996-3.
[7] See, e.g., Treas. Reg. § 25.2511-1(g)(1) and Harwood, 82 T.C. 239 (1984).
[8] For example, a purported seller-financed sale of a residence to a taxpayer’s son was not respected causing the subject property to be included in a taxable estate under IRC § 2036 in Estate of Maxwell v. Commissioner, 3 F.3d 591 (2d Cir. 1993). Advances purported to constitute loans were disrespected when there was an implied agreement the debt would not be enforced in Estate of Musgrove v. U.S., 33 Fed. Cl. 567 (1995), thereby including assets in the decedent’s estate under IRC §§ 2033, 2035, and 2038. Purported loans from family limited partnerships were treated as evidence of a retained right to enjoyment of FLP assets in Rosen, T.C. Memo 2006-115 and Moore, T.C. Memo 2020-40. When a decedent takes a deduction under IRC § 2053 for debts of their estate, it is similarly critical to have debts respected as such. See, e.g., Estate of Holland, T.C. Memo 1997-302; Estate of Duncan, T.C. Memo 2011-255; and Estate of Moore, T.C. Memo 2020-40.
