Two different cash advances from a mother to a son highlight when a purported loan will be respected as such for tax purposes. One case is Estate of Bolles,[1] which is an opinion I wrote about previously.[2] The other case is Estate of Galli.[3] The outcomes of the two cases are opposites – one finding bona fide debt and the other determining the advances to constitute a gift. The purpose of this writing is to examine why courts reached differing conclusions in these cases, offering a lesson on how to structure intrafamily loans.
Background
Both Bolles and Galli cited to Miller[4] which stands for the proposition that intrafamily transactions are presumed to constitute gifts, requiring a bona fide creditor-debtor relationship in order for a transaction to create bona fide indebtedness. In analyzing whether such relationship exists, the court will look at certain factors asking whether:
- There was a promissory note or other evidence of indebtedness;
- Interest was charged;
- There was security or collateral;
- There was a fixed maturity date;
- Demand for repayment was made;
- Actual repayment was made;
- The transferee had the ability to repay;
- Records were properly maintained by the transferor and/or the transferee reflected the transaction as a loan; and
- The parties treated the transaction as a loan for Federal income tax purposes.[5]
These factors are not exclusive.[6] However, they have commonly been cited as relevant to a determination of whether bona fide indebtedness exists.
Bolles and Galli
As discussed in my previous writing,[7] Bolles was an IRS victory. Given that writing, I will not go into detail about the facts in Bolles other than to show where relevant factors differed from Galli. In that case, Barbara Galli loaned $2.3 million to her son, Stephen. The transaction was documented in a written, unsecured, 9-year promissory note bearing interest at the applicable federal rate of interest (then 1.01%). The note required annual interest payments with a balloon payment of principal at maturity. Stephen made annual interest payments on time prior to his mother’s death while the note was in repayment at which point the note was extinguished as it passed to Stephen through her estate. For the years payments were made, Barbara reported Stephen’s payments as interest on her income tax returns.
As indicated, Galli, based on facts above, prevailed in achieving their intended treatment of the advance as a loan. Bolles did not (in part, the court agreeing certain advances were loans). A summary of some of the differences is:
| Feature
|
Galli
|
Bolles
|
| Documentation | Fixed, signed promissory note | No promissory notes, only informal records |
| Payments | Borrower consistently made timely payments | Borrower stopped making payments once in financial distress |
| Expectation of Repayment | High as borrower was financially capable of repaying | Low (for years determined to constitute a gift) as borrower was insolvent |
Although there were other differences, these were the primary differences related to the Miller factors. In Bolles, the taxpayer’s undoing was that advances were made after the borrower was insolvent, there were no written promissory notes, payments were not made, and no effort to collect was undertaken. On those facts, different than in Galli, the court determined the greater weight of the factors favored treating the advances as gifts.
Other Issues in Galli – Applicable Federal Rate of Interest and Duty of Consistency
Interestingly, in Galli, the IRS raised two other issues – the applicable federal rate of interest and a duty of consistency in tax reporting. While these issues do not directly relate to a comparison of Bolles and Galli, these issues warrant discussion.
The applicable federal rate of interest (“AFR”) is an interest rate published monthly by the Treasury calculated as provided by statute.[8] A bona fide loan that could otherwise constitute a gift, will not be considered a gift provided that interest on the loan is at the AFR.[9] When less than the AFR is charged, then the “forgone interest” is treated as a gift.[10] Although the interest rate charged in Galli equaled the AFR, the IRS argued the 1.01% rate of interest was below an arms-length rate, thereby causing there to be at least a partial loan. Citing to previous authority,[11] the Tax Court did not agree with the IRS. The court ruled that Congress “displaced the traditional fair market value methodology of valuation of below-market loans by substituting a discounting methodology” using the AFR. As a result, by statute, loans at the AFR cannot be “below market” for tax purposes even if the AFR is lower than an arms-length rate.
Another interesting issue raised in Galli was concern of the IRS about consistency in reporting. For gift tax purposes, since the advance from Barbara to Stephen was $2.3 million, the value of Stephen’s obligation to Barbara needed to equal that amount to avoid creating a gift. For reasons stated above, related to the AFR, the court found equivalency in value. For estate tax purposes, the estate reported Stephen’s obligation to equal $1,625,000, obviously less than $2.3 million even though no principal payments had been made.[12] However, estate tax is different than gift tax. An asset is included in a taxable estate at its value on date of death.[13] When the AFR is lower than prevailing arms-length interest rates, it is likely that a loan will be valued at less than its full-face value on an estate tax return. The court recognized this saying “[i]f the note is valued on the estate-tax return at less than face value, that is simply a reflection of different rules on characterizing transfers as gifts and loan valuation for the estate tax — not any violation of any duty of consistency.” As such, the IRS likewise did not prevail on this issue.
Conclusion
Bona fide debt cases are common in tax law, whether for income, gift, or estate tax matters. When related parties purport a transaction to constitute a debt, as indicated above, they can expect scrutiny. However, when structured and administered consistent with a genuine loan, this intended treatment should be respected. In tax law, we often hear the phrase “substance over form” indicating that the substance of a transaction should prevail over its form. Evaluating whether debt is bona fide is not a substance over form analysis, but it bears resemblance. Whenever debts are being entered into between related parties, the formalities should be respected – there should be a written promissory note, security provided when feasible, payments made on time, etc. Also, the “borrower” should be solvent and the “lender” should have a true expectation of repayment. Consulting with tax professionals to formalize the arrangement is important.
Beyond the existence of bona fide debt, the Galli case addressed other issues that have concerned the IRS. For some time, the IRS has seemingly been concerned that the AFR and related IRC § 7520 rate are insufficient to create an arms-length, fair market value loan (or other transaction as relevant under those authorities). Likewise, the IRS appears frustrated that loans can avoid constituting gifts when they may be reported as valued below face value on an estate tax return. Given the facts in Galli, some may question why the IRS even pursued the case. I speculate that it was to bring these issues before the court. To some extent, it is understandable that the IRS would have these concerns. However, as the court recognized, the law supports these outcomes. As such, until the law changes, the AFR should be considered adequate interest to avoid a loan constituting a partial gift (i.e. the difference between the AFR and third party, arms-length rates) and estate tax returns should continue to report assets at fair market value, which may discount intrafamily loans with interest at the AFR.
[1] Estate of Bolles v. Commissioner, 2024 WL 1364177 (9th Cir. 2024); T.C. Memo 2020-71.
[2] Edmondson, Gray, “Revisiting Intrafamily Loans – Bolles,” Jun. 4, 2024, https://esapllc.com/revisiting-intrafamily-loans-bolles-2024/.
[3] Estate of Galli, T.C. No. 7003-20 and 7005-20.
[4] Miller, T.C. Memo 1996-3.
[5] Id.
[6] Estate of Bolles, T.C. Memo 2020-71.
[7] See Footnote 2.
[8] IRC § 1274(d).
[9] IRC § 7872(e)(1).
[10] IRC §§ 7872(a) and (e)(2).
[11] Frazee v. Commissioner, 98 T.C. 554 (1992).
[12] As a note, Barbara did not file a gift tax return reporting the loan as a non-gift. Had she done so, the statute of limitations on that return may have expired before the filing of her estate tax return which generated this controversy. This case may also be a lesson to file a gift tax return, reporting non-gifts, to minimize the likelihood such transactions generate tax controversy at death.
[13] IRC § 2031.
