Dear Clients, Colleagues and Friends,
Any of you who have children know that as parents, we often want to help our adult children who need a financial boost – and this assistance frequently comes in the form of a loan. Loans are an effective and common way for parents to foster a child’s independence, encourage responsibility and signal their confidence that their child can succeed on his or her own. Moreover, with the current historically low interest rates, parents have less interest income to report and children can pay less interest than they would have had they borrowed from a bank. And unlike gifts, loans do not utilize any of your lifetime gift tax exemption, which currently stands at a record-high $11.58 million per person (indexed for inflation).
While intra-family loans are important tools that can be used to transfer wealth to the next generation, most parents are unaware that their actions and expectations with respect to repayment of the loan can transmute the loan into a gift, resulting in unintended estate and gift tax consequences. This is exactly what happened to Mary Bolles in the recent case of Estate of Mary P. Bolles v. Comm’r, T.C. Memo. 2020-71 (June 1, 2020).
Mary, a mother of five, made numerous loans to each of her children and kept meticulous records of each loan and any repayments. Between 1985 and 2007 Mary loaned her son Peter approximately $1.06 million to support his business ventures, even when it was clear he would not be able to make any payments on the loans. Moreover, none of the loans to Peter were ever formally documented, and Mary never attempted to enforce any of these loans.
In late 1989, Mary created a revocable living trust, which specifically excluded Peter from any distribution of her estate upon her death. Though she later amended her trust to no longer exclude Peter, she included a formula to account for the “loans” made to Peter in making distributions to her children. After her passing, the IRS took the position that the entire amount of the loan, plus accrued interest, was part of her estate – and assessed the estate with a tax deficiency of $1.15 million. The estate took the opposite position, claiming that the entire amount was a gift.
In its analysis, the court examined certain factors to be considered in deciding whether the advances were loans versus gifts. Noting that the determination depends not only on how the loan was structured and documented, the court emphasized that in the case of an intra-family loan, a critical consideration is whether there was an actual expectation of repayment and intent to enforce the debt. The court ultimately “split the baby,” holding that any advances prior to 1990 were in fact loans (since the evidence suggested that Mary reasonably expected that he would repay the loan up until he was disinherited from her trust in late 1989), and that those made after 1990 were gifts.
The takeaway from this case is that if you are currently thinking about taking advantage of the elevated gift tax exemption before it sunsets, it would be prudent to review any outstanding family loan transactions in order to determine the extent to which such loans may have been transmuted into gifts over the years that could adversely impact the amount of your remaining available exemption. Additionally, because actions may speak louder than words where family is involved, it is important to remember that you and your family should continue to treat any such loans as third-party loans in order to avoid any unintended estate tax consequences down the road.
Jeffrey M. Verdon, Esq.
For more information about any of the information discussed in this Client Alert, or any other income or estate tax planning or asset protection planning assistance, please contact the: Jeffrey M. Verdon Law Group, LLP at firstname.lastname@example.org or 949-333-8143.