July 1, 2024 / Newsletters, Publications

Intrafamily Transactions: When Lifetime Transfers Intended as Loans Are Treated as Gifts

by Corinne L. Adams

In a recent case, Estate of Mary Bolles, T.C. Memo 2020-71, affirmed, Docket No. 22-70192 (9th Cir, 2024), the Ninth Circuit Court of Appeals affirmed a Tax Court opinion which held that lifetime transfers from a mother to her son, while properly characterized initially as loans, ultimately became taxable gifts when there no longer existed any reasonable expectation of repayment. This case is significant to the taxpayers of California, as California is one of the states within the Ninth Circuit, the Bolles decision is now the applicable law in California.

Generally, intrafamily transfers are presumed to be gifts unless a genuine bona fide creditor-debtor relationship between the parties exists, whereby the lender reasonably expects to receive payment and intends to enforce the collection of the indebtedness.

In the Bolles case, Mary Bolles, a mother of five children, advanced funds to her children over several years and recorded these advances as “loans” with notations as to accrued interest and status of repayment.  Typically, each year Mary forgave the outstanding debt account for each child based on the gift tax annual exclusion.  From 1985 through 2007, Mary advanced over $1M to her eldest child, Peter, an aspiring architect who took over his father’s prosperous architecture practice in the San Francisco area.  While Peter’s architecture career seemed promising at the outset during which time he enjoyed initial success, the architecture firm later suffered financial difficulties and eventually closed.  Although Peter remained gainfully employed elsewhere, he ceased to make payments on the advances made by his mother after 1988. As further evidence of Peter’s financial troubles, a trust established by Peter’s father had pledged $600,000 as security for Peter’s business loan which Peter never satisfied and for which his father’s trust ultimately became liable.

Mary continued to advance Peter funds despite her knowledge of his financial situation and his inability to make payments toward the loans.  In 1989, Mary created a revocable trust which excluded Peter from any distribution of her estate upon her death and which was later amended to include a formula to offset Peter’s inheritance by the outstanding loans in existence at the time of Mary’s death.  In 1995, Peter signed an acknowledgment prepared by Mary’s estate planning attorney that he was unable to repay any of the amounts Mary had previously loaned to him and further agreed that the loans would be taken into account when distributions from the trust were made. Upon Mary’s death in 2010, the Internal Revenue Service assessed the estate with a gift tax deficiency of $1.15M finding that the advances from Mary to Peter from 1990 to 2007 were gifts.

Factors To Overcome the Presumption that Intrafamily Advances are Gifts

The parties relied on the long-standing factors enumerated in Miller v. Commissioner, T.C. Memo. 1996-3,113 F.3d 1241 (9th Cir. 1997) to determine whether the advances should be properly treated as loans or gifts.  These factors include:

1. There was a promissory note or other evidence of indebtedness;
2. Interest was charged;
3. There was security or collateral for the loan;
4. There was a fixed maturity date;
5. A demand for repayment was made;
6. Actual payment was made;
7. The transferee had the ability to repay the loan;
8. Records were maintained by the transferor; and
9. The manner in which the transaction was reported for Federal tax purposes was consistent with a loan.

The Court held that while these factors can rebut the presumption that intrafamily advances are gifts, they are not exclusive.  In addition, there must exist an actual expectation of repayment and an intent to enforce the debt.

In the Bolles case, while Mary kept records of the advances and accrued interest thereon, there were no promissory notes issued, no security for the advanced funds, and no attempts to enforce repayment.  Nonetheless, the Court held that the advances from 1985-1989 were in fact loans, and not gifts, because the circumstances indicated a bona fide creditor-debtor relationship wherein Mary had a reasonable expectation of repayment as Peter enjoyed initial professional success and as he was consistently making payments toward the advances.  However, the Court found that Mary’s advances to Peter from 1990-2007 could not be loans as there was no reasonable possibility of repayment, as evidenced by Peter’s default on his business loan, the closure of his architecture practice, his inability to make continued payments toward the advances, and Mary’s estate planning documents which treated the loans as advances on Peter’s inheritance.

Key Takeaways

The Court’s opinion in Bolles underscores the importance of properly documenting intrafamily loans, enforcing collection of the debt, and, perhaps most importantly, ensuring that the factual circumstances support a reasonable expectation of repayment.  These transfers will draw Internal Revenue Service scrutiny in which, objective facts rather than the parties’ stated intent, will be relied upon to discern the true nature of the transaction.  To secure the intended tax treatment of intrafamily advances as loans, it is critically important that the Miller factors described above support the existence of a bona fide creditor-debtor relationship. Intrafamily loans should be documented with signed promissory notes requiring the accrual of interest at no less than the Applicable Federal Rate for a term not longer than the lender’s life expectancy, secured by reasonable collateral, with a borrower who has the ability to render payment in accordance with the note terms and who so renders payment.  As Bolles indicates, the failure to do so may result in unfavorable tax treatment.

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