A recent Tax Court order highlights the gift and estate planning opportunities afforded when a senior family member makes loans to other family members. In Galli v. Commissioner, Docket Nos. 7003-20 and 7005-20, the Court had to decide whether a loan made by decedent to her son constituted a gift or partial gift, and also how the outstanding loan balance should be valued for estate tax purposes when the decedent died.
In 2013, the mother loaned $2.3 million to her son who was her only child. At the time when the loan was made, the mother was 79 years old. The son’s obligation to repay the indebtedness was evidenced by an unsecured promissory note. Interest was payable at the applicable federal rate, which at the time was a very low 1.01%. The note provided for payment of interest only for eight years with a balloon payment in year nine.
The mother died in 2016, when the interest rate was higher than it was in 2013 when the loan was made. The estate took the position that the loan was a bona fide indebtedness that should not be treated as a gift for federal gift tax purposes. The estate also took the position that the outstanding indebtedness reported on the estate tax return should be valued at $1,624,000 (a discount of $676,000 from the face amount of the promissory note) to reflect the higher interest rates in effect at the time when the mother died. The IRS challenged both of these positions alleging (1) that other factors in addition to charging the AFR interest rate needed to be taken into consideration for determining whether there was a gift, and (2) the full face value of the note had to be taken into consideration for estate tax purposes.
In Dickman v. Commissioner, 465 US 330 (1984), the Supreme Court held that an interest-free loan is a transfer of property by gift to the extent of the foregone interest, but did not establish a method to calculate the amount of the gift. In response, Internal Revenue Code Section 7872 was enacted. The Treasury publishes monthly “applicable federal rates” for a variety of tax-law purposes, including the distinction between loans with below-market interest rates that trigger gift-tax rules and those that do not.
The Tax Court in Galli ruled that a taxpayer can rely on the applicable federal rate for purposes of valuing a loan for gift tax purposes, even though it is significantly lower than the market rate, provided that there does not exist a significant repayment risk. The court also noted that even though a commercial lender would normally have required some form of collateral to secure the debtor’s obligation to repay the loan, this is not required for gift tax purposes.
The Court further held that the estate could rely on the prevailing AFR as of decedent’s date of death for purposes of valuing the outstanding balance due on the loan when decedent died. Valuing the note on the estate tax return at less than face value was simply a reflection of different rules on characterizing transfers as gifts and loan valuation for federal estate tax. There was no violation of any duty to treat the value of the loans consistently for gift and estate tax purposes.
The case provides estate planners with an opportunity to create valuation discounts by leveraging how the AFR is taken into account for gift and estate tax purposes.
