Intrafamily Transfer
A parent will sometimes transfer money to a child to enable the child to make an investment that the child could not otherwise make on their own.
For example, the child may have identified an attractive business opportunity but does not have sufficient assets or liquidity with which to make an investment therein, is unwilling or unable to sell other assets to raise the funds, and has not been able to borrow the necessary amount on acceptable terms from an unrelated lender because the market rate of interest may be too high, the repayment schedule may be too short, or the collateral requirements may be difficult to satisfy.
Enter the parent. After some discussion, the parent transfers enough money to the child to make the desired investment.
What is It?
Unfortunately, there are times when the parent and the child fail to agree on the nature of the transfer as a gift or as a loan, or, having agreed thereon, fail to memorialize their agreement or fail to act consistently with such agreement.
Under these circumstances, the parties to the transfer, or their successors, may end up taking inconsistent positions for tax purposes; for example, with the child treating the transfer as a gift while the parent’s estate[i] treats it as a loan.
In turn, the IRS may disregard the parties’ respective treatment of the transfer and seek to discover its true nature based upon whatever evidence it is able to gather.
Before discussing a recent decision of the U.S. Tax Court in which these issues were considered, and to better understand the Court’s reasoning, let’s walk through a not atypical fact pattern to introduce the applicable tax rules.
A Gift
Assume Mom transfers a sum of money to Son for no consideration; i.e., the transfer is not made in exchange for: (i) Son’s services to Mom (compensation); (ii) the transfer of his property to Mom (a sale); (iii) Mom’s use of his property (a lease or license); or (iv) Son’s promise to repay the amount transferred (a loan).
In other words, Mom has made a gift to Son.
Depending upon the amount of the gift, and the amount of any other gifts Mom may have made to Son during the same taxable year as the transfer in question, Mom may be required to file a federal gift tax return and remit payment of any gift tax owing.[ii]
A Loan or A Partial Gift?
If, in exchange for the transfer, Son gives Mom a note (which she accepts) pursuant to which he promises to repay her the amount of the transfer on or before a specified date, but does not agree to pay any interest to compensate Mom for his use of her money, Mom will be treated as having made a gift to Son of an amount equal to the forgone interest.[iii]
Alternatively, if Son agrees to periodically pay Mom a stated rate of interest to compensate her for his use of her money over a specified period of time, then Mom may be treated as having received sufficient consideration from Son, and no gift will have occurred.[iv]
In general, the sufficiency of the consideration received by a lender in exchange for the use of their money will depend upon the rate of interest charged by the lender with respect to the loan.
Below-Market Interest
Understandably, one may suppose that, in order for a lender to avoid partial gift treatment for a loan to a related person, the lender must charge a rate that is comparable to that charged by an unrelated person making such a loan under similar circumstances; in other words, a “fair market” rate of interest.[v]
From this, if the rate of interest charged is below the “fair market rate” for an identical loan, one may presume that the forgone interest – the “bargain” element, if you will – represents a gift from Mom to Son.[vi]
In fact, a below-market loan is treated as a “gift loan” where the forgoing of interest by the lender is in the nature of a gift.[vii] This is most likely to occur when the lender has a familial relationship with the borrower, as in the case of Mom and Son.[viii]
AFR
Notwithstanding the economic soundness of this conclusion, it is incorrect, at least under current law. A note will be treated as bearing an adequate rate of interest for purposes of the federal gift tax if the rate of interest is at least equal to the applicable federal rate (the “AFR”) for a loan of the same term, even where the fair market rate for such a loan exceeds the AFR.[ix] Such an interest-bearing loan avoids being a “below-market loan” for tax purposes and, so, there is no forgone interest to be treated as a gift for gift tax purposes.
However, if the rate used to calculate the interest on the loan is less than the AFR – i.e., if the loan is a “below-market loan” within the meaning of the Code[x] – then the lender will generally be treated as having made a gift on the date of the loan for purposes of the gift tax.[xi] The amount of such gift is equal to the amount loaned over the present value of all payments (including the stated interest) required to be made under the terms of the loan.[xii] In other words, the transfer is treated as a “partial” gift.
To appreciate the significance of this deviation from conventional gift valuation principles – because the AFR is generally lower than the fair market rate of interest that may be charged by an unrelated lender for an identical loan to an unrelated borrower – we must consider the estate tax consequences of Mom’s death.
Mom’s Gross Estate
Assume Mom dies before her loan to Son has been satisfied.
Of course, the loan receivable held by Mom at the time of her death, as reflected in the note that Son gave her in exchange for the loan, will be included in Mom’s gross estate for purposes of determining her federal estate tax liability.[xiii]
FMV of the Note
The value of every item of property includible in a decedent’s gross estate is its fair market value (“FMV”) at the time of the decedent’s death.[xiv]
The FMV of a property is the price at which the property would change hands “between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”[xv]
What, then, is the FMV of Son’s indebtedness to Mom at the time of her death?
According to the IRS, the FMV of a note that is included in the gross estate of a decedent (the lender, in this case) is presumed to be the amount of the unpaid loan, plus any accrued but unpaid interest[xvi] to the date of death.[xvii]
If the FMV of the note is not reported on the estate tax return at this value, the estate must submit satisfactory evidence to the IRS that the note is worth less than such value,[xviii] or that the note is uncollectible, either in whole or in part,[xix] and that any property pledged or mortgaged by the borrower as security for the satisfaction of the loan is insufficient to satisfy the obligation.
Among the factors to be considered in determining the FMV of the note are its interest rate, whether the note is secured or unsecured, the liquid or illiquid nature of the security, the FMV of any security, the remaining term of the note, the obligor’s credit history, and the obligor’s ability to satisfy the note.[xx]
Interestingly, in determining an obligor’s ability to satisfy a debt that is included in the estate of a deceased creditor, neither the creditor’s testamentary cancellation of such debt, nor the testamentary transfer of other property from the creditor’s estate to the obligor as a beneficiary of the estate, is relevant.[xxi]
Inconsistent Treatment
Typically, a taxpayer making a loan to a family member takes back a borrower note bearing the minimum interest rate required to ensure that the loan is not treated as a below-market loan for federal gift tax purposes; i.e., the AFR. The taxpayer claims that this interest rate is sufficient to avoid the treatment of any part of the transaction as a gift.
However, in subsequently valuing the unpaid note as an asset of the lender’s estate for purposes of the federal estate tax, the lender’s estate may take the position that the FMV of the note should be discounted because the interest rate is below the market rate of interest at the time of the lender’s death.
In other words, the lender-taxpayer relies on the statutory rules to assert that the loan is not below market for gift tax purposes at the time of the loan, but relies on the underlying economic characteristics of the loan to assert that the loan is “below market” for estate tax purposes and, thus, its fair market value is less than its unpaid principal balance.
With the foregoing principles in mind, let’s turn to the Tax Court decision that was referenced earlier.[xxii]
The Loan In Question
Taxpayer was Decedent’s only child and the executor of Decedent’s estate. About three years prior to her death, when Decedent was 79 years of age, Decedent transferred $2.3 million to Taxpayer. The two parties to the transfer prepared and executed a simple note in which Decedent’s transfer to Taxpayer was described as a loan.
Loan Terms
The loan was unsecured, meaning it must have been fully recourse against Taxpayer;[xxiii] it bore interest at an annual rate of 1.01 percent, which was the mid-term AFR for the month in which the transfer was made;[xxiv] had a term of 9 years,[xxv] which was just shy of Decedent’s life expectancy[xxvi] at the time of the transfer; and provided for annual payments of interest, with repayment of the entire principal at the end of the term.[xxvii]
Treatment as a Loan
Decedent and Taxpayer treated the above transfer as a loan, not as a gift. Therefore, Decedent never filed a gift-tax return[xxviii] to report the transfer.
Taxpayer made annual payments of interest to Decedent, as required under the note.[xxix] There did not appear to have been any defaults under the note.
Decedent included this interest in her gross income as it was received.[xxx]
Decedent’s Death
When Decedent died, Taxpayer inherited the note,[xxxi] which meant that Decedent’s creditor interest and Taxpayer’s debtor interest were merged together, thereby extinguishing Taxpayer’s indebtedness to Decedent.[xxxii]
Notwithstanding the extinguishment of the debt, the note was included in Decedent’s estate[xxxiii] and reported as an asset on Decedent’s estate tax return.[xxxiv]
Based upon the terms of the note, Decedent’s estate valued the note at $1.624 million, notwithstanding the note had an unpaid principal balance of $2.3 million at the time of Decedent’s death.[xxxv]
IRS Audit
Following its examination of Decedent’s estate tax return, including Decedent’s lifetime transfer to Taxpayer (i.e., the loan), the IRS challenged the Decedent’s and her estate’s gift tax and estate tax treatment of the transfer, and issued a notice of deficiency to the estate for nonpayment of gift tax, based upon the “true” nature of the transfer,[xxxvi] and another notice for underpayment of estate tax, based upon the unreported value of the gift.
As the executor of Decedent’s estate, Taxpayer filed timely petitions with the Tax Court to protest the gift and estate tax liabilities asserted by the IRS in the notices of deficiency.[xxxvii]
According to Taxpayer, the IRS was not trying to recharacterize Decedent’s entire transfer to Taxpayer as a gift, but only a portion thereof, based on the rate of interest imposed under the note. Taxpayer countered that the transfer was “a pure loan” because Decedent charged interest at the statutorily prescribed AFR, which meant that no part of the transfer constituted a gift. Because there was no gift, Taxpayer continued, Decedent did not have to file a gift tax return to report the transfer, nor was Decedent’s estate required to report any portion of the transfer on its estate tax return[xxxviii] as a previously unreported gift on which no gift tax was paid.
Taxpayer also explained that the reported FMV for the note on Decedent’s estate tax return – an amount less than the outstanding balance of the note (in this case, the note’s face value) – was “simply a reflection of different rules on characterizing transfers as gifts and loan valuation for the estate tax.” It did not represent a violation of any duty of consistency.
The Tax Court’s Analysis
The main issue before the Court was the proper classification of the lifetime transfer of money from Decedent to Taxpayer.
The Court observed that resolution of the gift tax issue depended entirely on whether the transfer in question was a gift or a partial gift. It added that resolution of the estate tax issue depended on the resolution of the gift tax issue.
IRS’s Position
The Court reviewed the IRS’s argument that the amount by which the value of the money loaned by Decedent exceeded the FMV of the right to repayment, set forth in Taxpayer’s note, was a previously unreported and untaxed gift.
According to the IRS, the present FMV of future payments to be made under a note, determined as of the time when the loan was made, may be discounted to reflect only the time value of money where there is no significant risk that the loan will not be repaid.
In contrast, where significant repayment risk is present, the present FMV of future payments must take into account the risk of non-payment, in addition to any discount required to reflect the time value of money.
The value at which Decedent’s estate reported Taxpayer’s note on its estate tax return, the IRS stated, was based upon a discounted value for the future payments due under the note, which reflected the risk of non-payment.
The principles of asset valuation, the IRS continued, should be applied consistently for gift tax and estate tax purposes. Indeed, according to the IRS, there was a duty of consistency that precluded Decedent’s estate from maintaining inconsistent valuation approaches for gift and estate tax in order to avoid gift tax on a transaction, such as the loan, that was designed to reduce estate tax. Accordingly, the IRC concluded there was a previously unreported and untaxed gift subject to estate tax.
Alternatively, the IRS stated that, for purposes of determining the value of Decedent’s gross estate, the FMV of Taxpayer’s note should be determined by discounting the value of the future payments under the note to reflect time value of money considerations only, by applying the AFR, which mirrored Decedent’ approach for not reporting a gift with respect to the loan.
Court’s Response
The Court agreed with Taxpayer that the IRS was not asserting that the transfer from Decedent to Taxpayer was entirely a gift; rather, the IRS sought to treat the transfer as only partially a gift, either because Taxpayer’s note set too low an interest rate, or because the note’s reported value on the estate tax return filed by Decedent’s estate implicitly amounted to an admission that the transfer was partially a gift.
The Court also agreed with Taxpayer that, because Decedent’s loan to Taxpayer charged interest at the AFR, it was not a below-market loan with forgone interest that should be treated as a gift.
Next, the Court addressed the question of whether a loan should be treated as a partial gift if it carries an interest rate below fair market but equal to or above the AFR. The Court stated that it had rejected this argument years before, and explained that Congress had “displaced the traditional fair market methodology of valuation of below-market loans by substituting a discounting methodology” using the AFR.[xxxix]
Based on the foregoing, the Court determined that Decedent’s loan to Taxpayer did not result in a gift.
Thoughts On Inconsistencies
Good result for certain taxpayers, right? But does it make sense?
Below-Market Loans
Does it make sense that the value of the consideration given by one person (the borrower) to a related person (the lender) in exchange for a sum of money that purports to be a loan be measured only by reference to the term of the loan and whether the interest charged is equal to the AFR, a rate that is concededly lower than the rate that would be charged for the same loan between unrelated parties?
Where the lender dies before the loan has been satisfied, so that the unpaid balance of the loan is included in the deceased lender’s gross estate for purposes of the estate tax, does it make sense that the fair market value of the loan is determined not only by reference to the term of the loan, but also by considering a litany of other factors, including the amount of interest charged relative to what would have been a fair market rate between unrelated individuals under identical circumstances, the presence and value of collateral securing the loan, the ease of converting such collateral to money, the borrower’s credit history, as well as their balance sheet and cashflow statements?
Over the years, the rules for below-market loans have allowed taxpayers to take inconsistent positions regarding the valuation of loans to achieve tax savings. The lender avoids making a taxable gift to the related borrower merely by charging interest at a lower than fair market rate equal to the AFR. If the lender dies before the loan is repaid, the estate tax value of the remaining loan balance is discounted because the interest rate (the AFR) is below the fair market rate at the time of the lender’s death. In other words, the lender relies on the statutory rules to assert that the loan is not below market for gift tax purposes at the time of the loan transaction but relies on the underlying economic characteristics later to assert the loan is below market for estate tax purposes.
In response to this inconsistent treatment, the last Administration[xl] sought to impose a consistency requirement by providing that, if a taxpayer treated any promissory note as having a sufficient rate of interest to avoid the treatment of any part of the transaction as a gift, that note subsequently had to be valued for federal estate tax purposes by limiting the discount rate to no more than the greater of the actual rate of interest of the note, or the applicable minimum interest rate for the remaining term of the note on the date of death.[xli]
This proposal never got out of Congress.
Grantor Trusts
The last Administration also targeted another inconsistency of which individual taxpayers have been taking advantage for years to save on income, gift and estate taxes; specifically, the differences in income, gift, and estate tax treatment for a transfer of property between an individual and an irrevocable trust of which the individual is treated as the owner for purposes of the income tax by virtue of having retained certain powers over the trust or its assets.
The deemed owner of a grantor trust is treated as owning the assets of the trust solely for income tax purposes, but the trust is respected as a separate taxpayer for purposes of the gift tax. As a result, sales and other transactions between a grantor trust and its deemed owner are disregarded for income tax purposes so no income tax is incurred with respect to the gain realized, but no taxable gift will have occurred provided the grantor trust exchanges sufficient consideration[xlii] with the grantor for the property transferred to the trust.
In general, the proposal would have treated the transfer of an asset for consideration between a grantor trust and its deemed owner as one that is regarded for income tax purposes, which would result in the seller recognizing gain on any appreciation in the transferred asset, and the basis of the transferred asset in the hands of the buyer being the amount the buyer paid to the seller.
Congress was not keen on eliminating this inconsistency.
Basis
It appears that the only recent success Congress has had in eliminating the inconsistent treatment of with gift or estate tax consequences has been the amendment of the basis step-up rules to require consistency between the estate tax value of property and the basis of property acquired from a decedent.[xliii] Under that amendment, which applies to property the inclusion of which in the decedent’s estate increased the liability for estate tax on such estate, if the value of property has been finally determined for estate tax purposes, then the basis in the hands of the recipient can be no greater than the value of the property as finally determined.[xliv]
What’s Next?
It will be some time before we see any opportunity, let alone any movement, toward removing the inconsistencies on which so much estate tax and gift tax planning depend. Indeed, these taxes may even be eliminated before such an opportunity arises again.
In the meantime, we have to identify the purpose for which these federal transfer taxes are imposed. Do they contribute much to the federal fisc? How much does it cost the IRS to enforce compliance? How much do the targeted taxpayers spend on avoiding or reducing the economic impact of these taxes? Do these taxes in any way modify the behavior of those to whom they are applied? Are these folks dissuaded from engaging in what we, as a society, have determined is harmful conduct, or do the taxes encourage “good behavior”? Is the net outcome satisfactory, if not from a fiscal perspective, then from that of having realized a societal objective?
If none of these questions can be answered in the affirmative, then it’s time we honestly consider whether there are better alternatives.
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[i] And the child’s siblings?
[ii] IRC Sec. 6019.
[iii] The “forgone interest.”
[iv] A loan will be especially attractive when interest rates are low. In that case, the return on the borrower’s investment of the loan proceeds may more easily exceed the cost of borrowing.
[v] As we will see shortly, many factors are taken into account in setting this rate.
[vi] According to the IRS, “[t]ransfers reached by the gift tax are not confined to those only which, being without a valuable consideration, accord with the common law concept of gifts, but embrace as well sales, exchanges, and other dispositions of property for a consideration to the extent that the value of the property transferred by the donor exceeds the value in money or money’s worth of the consideration given therefor.” Reg. Sec. 25.2512-8.
[vii] IRC Sec. 7872(f)(3).
[viii] The nature of the economic benefit bestowed upon the borrower by the below market loan will depend upon the relationship between the parties. For example, compensation may result if the benefit arises from an employer-employee relationship, while a dividend or other distribution may arise from a corporation-shareholder relationship.
[ix] The AFR for a debt instrument is based on the term of the instrument (i.e., short-term, mid-term, or long-term). See IRC Sec. 1274(d)(1). https://www.law.cornell.edu/uscode/text/26/1274. It is published by the IRS for each month. Reg. Sec. 1.1274-4(b). It is based on the yield to maturity of outstanding marketable obligations of the United States of similar maturities during the one month period ending on the 14th day of the month preceding the month for which the rates are applicable. See Reg. Sec. 601.601(d)(2)(ii). In other words, it is the rate at which the federal government can borrow.
[x] IRC Sec. 7872(e)(1).
A below-market loan includes a term loan if the amount loaned exceeds the present value of all payments due under the loan. IRC Sec. 7872(e)(1). The present value of any payment is determined as of the date of the loan by using a discount rate equal to the AFR. IRC Sec. 7872(f)(1).
[xi] IRC Sec. 7872(d)(2).
[xii] IRC Sec. 7872(b)(1).
[xiii] The estate tax is imposed on a decedent’s taxable estate. IRC Sec. 2001. The taxable estate is the value of the gross estate minus the deductions allowed by the Code. IRC Sec. 2051. The value of the gross estate includes the value of all property to the extent of the decedent’s interest therein at the time of their death. IRC Sec. 2033.
[xiv] Reg. Sec. 20.2031-1(b).
[xv] Reg. Sec. 20.2031-1(b).
[xvi] However, items of interest are separately stated on the estate tax return.
[xvii] Reg. Sec. 20.2031-4.
[xviii] Whether because of the interest rate, or other factor.
[xix] For example, by reason of the insolvency of the obligor, or for some other reason.
[xx] Reg. Sec. 20.2031-4.
[xxi] Estate of Harper v. Comm’r, 11 T.C. 717 (1948), acq., 1949-1 C.B.
[xxii] Estate of Galli v. Comm’r, T.C. Docket Nos. 7003-207005-20, Decided March 5, 2025.
[xxiii] Meaning Decedent, as the lender, could have taken any of Taxpayer’s assets to satisfy the loan in the event Taxpayer defaulted. The opinion gives no indication of Taxpayer’s ability to satisfy the debt. It is doubtful there was a UCC filing with respect to the loan.
[xxiv] According to IRC Sec. 1274(d), a mid-term loan is one with a term of more than 3 but not more than 9 years; a short-term loan is one with a term of not more than 3 years; a long-term loan is one with a term of more than 9 years. See also IRC Sec. 7872(f)(2).
[xxv] There was no indication in the Court’s opinion that Decedent’s health was such that she was unlikely to live out her life expectancy or the term of the loan. At the same time, there was no indication of longevity in Decedent’s family.
[xxvi] A life expectancy of approximately 90 years (for a 79 year old woman in 2013) according to the Social Security Administration. https://www.ssa.gov/oact/STATS/table4c6_2009_TR2013.html .
[xxvii] A balloon payment.
[xxviii] On IRS Form 709. U.S. Gift (and Generation-Skipping Transfer) Tax Return.
[xxix] There is no indication in the opinion regarding Taxpayer’s use of the loan proceeds or of Taxpayer’s tax treatment of the interest paid to Decedent.
[xxx] IRC Sec. 61.
[xxxi] At some point after making the loan to Taxpayer, Decedent must have revised her will or revocable trust to direct the transfer of the note to Taxpayer. Query when this was done, and how it would affect the tax treatment of the transfer. Facts and circumstances.
[xxxii] Because the extinguishment of the debt occurred as a testamentary transfer, Taxpayer (as the debtor) did not realize cancellation of indebtedness income under IRC Sec. 61(a)(11). See IRC Sec. 102, which provides that gross income does not include any amount received as a gift or as a bequest.
[xxxiii] Reg. Sec. 20.2033-1(b).
[xxxiv] Presumably, together with any accrued but unpaid interest thereon. IRS Form 706, U.S. Estate (and Generation-Skipping Transfer) Tax Return.
[xxxv] A discount from the face amount of the note of approximately 30%.
[xxxvi] The IRS claimed that Taxpayer’s note lacked the provisions necessary to create a legally enforceable right to repayment that was reasonably comparable to the loans made between unrelated persons “in the commercial marketplace.”
Likewise, the IRS claimed Taxpayer failed to establish that Decedent intended to create a legally enforceable loan, or that Decedent expected repayment.[xxxvi]
The agency also stated that Taxpayer, as the borrower and obligor on the note, failed to show that he had the ability or the intent to repay the loan.
In response to the foregoing, Taxpayer submitted copies of Mom’s bank record showing a transfer of $2.3 million, the note they both signed, Taxpayer’s own bank records that showed he paid interest to Mom each year, and Mom’s income tax returns showing she reported such payments as interest income.
[xxxvii] IRC Sec. 6212 and 6213; Tax Court Rule 34.
[xxxviii] IRS Form 706.
[xxxix] Under IRC Sec. 7872.
[xl] General Explanations of the Administration’s Fiscal Year 2025 Revenue Proposals.
[xli] The IRS would be granted regulatory authority to establish exceptions to account for any difference between the applicable minimum interest rate at the issuance of the note and the actual interest rate of the note. In addition, the term of any note (regardless of its rate of interest) would be shortened for purposes of valuing that note if there was a reasonable likelihood that the note would be satisfied sooner than the specified payment date and in other situations as determined by the Secretary. For example, the note may be treated as being short term regardless of the due date, a term loan may be valued as a demand loan in which the lender can require immediate payment in full, or the stated term may be reduced to the earliest possible date on which the related property (such as an investment in a life insurance policy) could be monetized.
[xlii] For example, a promissory note bearing interest at the AFR.
[xliii] The value of an asset for purposes of the estate tax generally is the FMV at the time of death. The basis of property acquired from a decedent generally is the FMV of the property at the time of the decedent’s death. Under regulations, the FMV of the property at the date of the decedent’s death is deemed to be its value as appraised for estate tax purposes. Prior to this amendment, however, the value of property as reported on the decedent’s estate tax return provided only a rebuttable presumption of the property’s basis in the hands of the heir. Unless the heir was estopped by their previous actions or statements with regard to the estate tax valuation, the heir could rebut the use of the estate’s valuation as their basis by clear and convincing evidence. The heir was free to rebut the presumption in two situations: (1) the heir had not used the estate tax value for tax purposes, the IRS had not relied on the heir’s representations, and the statute of limitations on assessments had not barred adjustments; and (2) the heir did not have a special relationship to the estate which imposed a duty of consistency.
[xliv] P.L. 114-41, The ”Surface Transportation and Veterans Health Care Choice Improvement Act of 2015.” IRC Sec. 1014(f) and Sec. 6035. The provision is applicable to property with respect to which an estate tax return was filed after the date of enactment (July 31, 2015).
