Bolles v. Commissioner Highlights the Intricacies and Traps of Intrafamily Loans

The Ninth Circuit of Appeals recently affirmed a Tax Court decision that certain intrafamily transfers of money that were originally characterized as loans became taxable gifts after the reasonable expectation of repayment diminished over the years. The Court rejected both the estate’s and the government’s arguments that the nature of the transfers as loans or gifts were all-or-nothing.  

Benefits of Intrafamily Loans

Intrafamily loans, as the name suggests, are lending arrangements between two family members. A family member may loan another family member money to help with a large purchase or education expenses. They may also loan money in order to shift wealth to a lower generation without triggering significant estate and gift tax consequences.

To do so, the family member would enter into a loan arrangement with the other family member and charge the lowest interest rate they may charge under IRS rules (sometimes referred to as the “hurdle rate”). If the recipient of the loan invests the money and it grows at a rate greater than the interest rate on the loan, the lender will have essentially shifted that growth out of their taxable estate to the recipient without triggering estate or gift tax.

Intrafamily Loan Requirements

The use of intrafamily loans to transfer assets to children is a common estate planning strategy. However, as this case shows, it is necessary to be able to show that these loans are truly treated as a debt to be repaid, and not loans in name only.  IRS will consider an intrafamily transfer to be a valid loan provided there was a “bona-fide creditor-debtor relationship” between the family members. In order to determine if there was a bona-fide creditor-debtor relationship, the IRS will look to several factors, including:

• Security of the loan,
• Attempts to enforce payments,
• Evidence of repayments,
• Financial ability to repay,
• Intent to enforce the debt and,
• Expectation of repayment.

The Tax Court notes in its opinion that the “actual expectation of repayment and an intent to enforce the debt are critical” when claiming a transaction should be characterized as a loan.

Background of Bolles v. Commissioner

The case dealt with transfers between a mother and her children. Over her lifetime, Mary Bolles transferred money to her children and characterized these transfers as loans. Mary allowed the interest to accrue each year, and at the end of the year, she forgave any outstanding interest, up to the annual exclusion amount. She properly documented all repayments.

Over a 22-year period, Mary transferred over $1.5 million to her son, Peter, in what were characterized as business loans. Over that period, Peter became increasingly in arrears on personal and business debts. In 1989, Mary altered her estate plan to remove Peter as a beneficiary of her revocable trust, then further amended it to include a formula for distributions to account for the loans made to Peter during her lifetime. Contemporaneous to the second amendment of Mary’s estate plan, Peter signed a document stating that he was unable to make repayments on these loans.

Upon Mary’s death, her estate claimed these unpaid loans had a fair market value of $0. The IRS recharacterized these loans as lifetime gifts subject to the estate and gift tax, resulting in an estate tax deficiency. As a result of the inclusion of the full loan amounts, the forgiven interest amounts no longer qualified for annual exclusion treatment and became includible in the gross estate as well.

Reasoning of the Courts

The IRS argued that all the loans should be considered gifts, while the decedent’s representatives argued that the amounts forwarded should all be treated as bona fide loans. Both the Tax Court and the Ninth Circuit rejected the estate’s arguments that the character of the transfers could either be only loans or only gifts.

Both courts focused on the requirement that there be a reasonable expectation of repayment. The Tax Court concluded, and the Ninth Circuit affirmed, that transfers from 1985-1989 could be considered bona fide loans as the decedent had a reasonable expectation of repayment. However, the courts concluded that after 1989 there were no attempts to enforce repayments and no longer a reasonable expectation of repayment. Accordingly, transfers made after 1989 were properly characterized as gifts.