Tax Tips
| Publication year | 1980 |
| Pages | 1859 |
1980, September, Pg. 1859. Tax Tips
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Intra-family sales and interest-free loans provide a number of income, estate and gift tax planning opportunities. Because of the substantial tax savings potential, the IRS has made a number of attacks on these arrangements. This column examines the uses and potential problems of these planning techniques.
An installment sale can be a useful device for transferring assets down to younger generations. The primary estate tax benefit from such a sale is the conversion of an appreciating asset (e.g., farmland, an apartment building, real estate or stock in a closely held corporation) into an installment note which will slowly decline in value as payments are made. This arrangement allows the older generation to freeze the value of the assets in their estate without an expensive preferred stock recapitalization or other device.(fn1) In the case of an income-producing asset, the older generation can often trade ordinary income for a mix of interest, capital gain and a return of basis.(fn2)
The interest-free loan is a useful alternative to an outright gift or a short-term trust. If a parent loans his children $100,000 interest-free, they should be able to invest the money and earn enough to pay for their college educations. The interest or other income is then taxed at the children's tax brackets. Such loans also offer potential savings for estate tax purposes. For example, a parent can loan his children the money to purchase an attractive stock or real estate investment. As with the installment sale, all appreciation accrues to the child, while the value of the note in the parent's estate remains fixed.
Both the installment sale and the interest-free loan can be used as a way of maximizing the use of the annual exclusions. Although a large chunk of property is transferred currently, only the net value of the property represents a gift.(fn3) The balance of the value can be transferred in increments by forgiving a portion of the debt each year. The result is an "installment gift," which maximizes the use of the annual exclusions. Because of the substantial tax savings potential, the IRS has attacked these arrangements on a number of different grounds.
If the child actually makes all the installment payments when due, and assuming a fair purchase price, there would be little
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room for attack. If the payments are forgiven as they become due, however, the IRS has announced in a Revenue Ruling that it will attack the transaction as not being a bonafide sale.(fn4) As a result, the entire value of the property sold would be a gift in the year of the "sale," and the donor/seller would not be able to use his annual exclusions to avoid the gift tax.(fn5)
The facts of the Ruling make as strong a case as possible for the IRS: "D" intended to give Whiteacre to "A." Upon advice of his attorney, instead of a gift of Whiteacre, D agreed to sell the property to A in exchange for a series of $3,000 non-interest-bearing, non-negotiable notes which matured on January 1 of succeeding years. The notes were secured by a purchase money mortgage. The terms of the sale were all arranged by D's attorney. The IRS concluded on these facts that the notes were never really intended as consideration. Since the notes were not intended as consideration, the transaction was "merely a disguised gift."
The only case on point cited by the IRS in support of its position is Minnie E. Deal.(fn6) In Deal, the taxpayer sold a remainder interest to her daughters for non-interest-bearing demand notes and $3,000 of each note was forgiven annually. The court in Deal held that the notes were not really intended as consideration by any of the parties and, therefore, the transfer of the remainder interest was a gift, rather than a bonafide sale.
The Ruling specifically states that the IRS will not follow two Tax Court cases on this issue, which it lost: Selsor R. Haygood,(fn7) and J.W. Kelley.(fn8) The facts in Haygood, Kelley, Deal and the Revenue Ruling are all similar: (1) the donor at all times intended to forgive the notes; (2) the notes were interest-free; (3) the property involved was non-income producing; and (4) aside from the possibility of selling the purchased property, the buyers had no funds to repay the notes.
The Deal case (the IRS victory) involved notes which were unsecured, while Haygood and Kelley (the taxpayer victories) both involved vendor's lien notes. The court in Deal seemed to conclude that the notes might well be unenforceable since "... the notes executed by the daughters were not intended to be enforced and were not intended as consideration for the transfer....(fn9)
In Haygood, the Tax Court used this factor to distinguish Deal:
The Minnie E. Deal case is clearly distinguishable on its facts from the instant case. Here the notes were...
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