Adventures in Forgiveness and Forgetfulness: Intra-family Loans for Beginners

• Publication year: 2007
• Author: By Philip J. Hayes

ADVENTURES IN FORGIVENESS AND FORGETFULNESS: INTRA-FAMILY LOANS FOR BEGINNERS

By Philip J. Hayes^*

Love is an act of endless forgiveness, a tender look which becomes a habit.¹

Prearranged staged forgiveness of a loan is a gift of the entire loan amount.²

I. INTRODUCTION

Estate planning practitioners should more often utilize conventional, straightforward intra-family loans to save transfer taxes for their clients. Although the technique is certainly not as sexy as, say, a sale to a grantor trust, private annuity, or a self-canceling installment note transaction, the humble intra-family loan is effective and easily understood. Clients can grasp the fundamental concept: the applicable federal rate (AFR) is a government-sanctioned bargain rate.

In the author's experience, the use of intra-family loans diverges greatly within the community of estate planners. Many planners survive with only a "need to know" grasp of the income and gift tax rules implicated by the conventional intra-family loan or sale, and fail to exploit the opportunities. Others use loans at the AFR habitually. The main reason for this divergence could be that the statutes and regulations governing intra-family loans (and intra-family sales) appear Byzantine to anyone without a strong income tax background. One cannot hope to figure out a complex loan issue by picking up the code, at least this author could not. Hopefully just these caring, empathetic words are comfort to those who have found it difficult, after several readings, to understand the scheme, let alone explain it to a client. By demystifying the authority (statutes and, unfortunately, case law) governing intra-family loans and sales, we shall open the door to satisfied clients, greater professional fulfillment, and a happier life.

This article will be presented in two parts. Part I will mainly cover intra-family loans under Section 7872 of the Internal Revenue Code. Part II will address intra-family sales, focusing on the messy intersection of the income tax safe harbors under Sections 1274³ and 483 on the one hand, and income and gift tax safe harbors under Section 7872 on the other.

II. HISTORY AND CONTEXT

A. In the Beginning

Once upon a time, life was good. Gas was 20 cents a gallon, Get Smart reruns ran daily, hard-core speed death-metal music had not been invented, personal interest was deductible, and even the most unsophisticated tax advisors knew enough to use interest-free loans to help clients drive large semi-trailers through gaping holes in the income and gift tax systems.

During this tax utopia, taxpayers used interest-free loans in a variety of ways to exploit the failure of the Internal Revenue Service ("IRS" or "Service") to at first assert, then later convince the courts, that interest-free loans should be income- and/or gift-taxable transfers. This exploitation included interest-free loans:

• by C corporations (usually closely-held) to shareholders (to avoid double taxation);
• by wealthy persons to family members in lower tax brackets to permit them to invest and receive returns taxed at lower rates;
• by employers to employees as a substitute for taxable compensation (and payroll taxes); and by sellers using installment sales to convert interest income to capital gain.

This tax Shangri-La lasted, for the most part, from 1913 to 1984.⁴

The IRS was slow to catch on to the potential for tax avoidance, failing to strongly assert that interest-free loans should have tax consequences until 1960, when, in Dean v. Commissioner,⁵ it made its first coherent argument. In Dean, the Commissioner argued that since an interest-free loan did not require an interest payment, the borrower received the free use of the principal as an economic benefit that should be included in gross income. At first the courts were not moved by the IRS's position.⁶ Eventually, however, the United States Court of Claims adopted the theory, although they were reversed.⁷ Finally, in 1984, the IRS scored its breakthrough victory in this arena (albeit in the gift tax context), in Dickman v. Commissioner,⁸ in which the U.S. Supreme Court held that the lender's right to receive interest is a "valuable property right," and that the transfer of such a right through an interest free loan is a taxable gift.

Dickman quickly touched off comprehensive below-market loan reform. Later in 1984, Congress enacted Internal Revenue Code section 7872⁹ to govern certain below-market loans. With Section 7872, Congress created artificial transfers of deemed interest between the borrower and the lender, to ensure that income was recognized by each party.¹⁰ Although Dickman concerned only gift tax, Section 7872 went beyond mere codification of the Dickman holding, and beyond the intra-family context, to reach loans to shareholders, employees and a variety of other below-market loans, for both income tax and gift tax application. By enacting Section 7872, Congress indicated that virtually all gifts involving the transfer of money or property would be valued using the currently applicable AFR,¹¹ thereby replacing the traditional fair-market-value method¹² of valuing below-market loans with a discounting method.

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Section 7872 proposed regulations were issued in August 1985,¹³ a portion of which were also adopted as temporary regulations.¹⁴ Unfortunately, the statute was amended after the promulgation of the Proposed Regulations, leading to the confusing mis-alignment of the statute and the Proposed Regulations discussed below.

B. Section 7872, Generally

Section 7872 governs below-market loans in several circumstances, including loans between family members.¹⁵ Section 7872 applies to any transaction that 1) is a bona-fide loan, 2) is below market, 3) falls within one of four categories of below-market loans, and 4) is not within any of several exceptions. The four categories are loans 1) from donor to a donee, 2) from an employer to an employee, 3) from a corporation to a shareholder, and 4) with interest arrangements made for tax avoidance purposes.¹⁶ As we are concerned solely with intra-family transactions, in this article we shall be concerned only with "gift loans."¹⁷

Generally, Section 7872 will not impute gift or income tax consequences to a loan providing "sufficient" stated interest, which means interest at a rate no lower than the appropriate AFR, based on the appropriate compounding period.¹⁸

Any gift loan subject to Section 7872 which bears interest below the AFR may have adverse tax consequences to the lender.¹⁹ Section 7872 treats a bona fide below-market (i.e., below-AFR) gift loan as economically equivalent to a loan bearing interest at the AFR coupled with a payment by the lender to the borrower of funds to pay the imputed interest to the lender. This "foregone interest" is treated as retransferred by the borrower to the lender as interest. Thus, the foregone interest is treated as a gift by the lender to the borrower and then treated as income to the lender from the borrower. Although income and gift taxes are implicated, the amount of the gift and income do not always align.²⁰

Section 7872 is complicated, therefore not well understood, and, in practice, often ignored. The problem is exacerbated in sales transactions, which implicate both the income and gift-tax safe harbor of Section 7872 and the overlapping income tax (and gift tax?) safe harbors of Sections 483 and 1274 governing intra-family sales. As we will discover in Part II of this article, with sales transactions, even if the correct safe harbor is used, the Code²¹ may impute phantom income annually if the loan does not call for "qualified stated interest" (e.g., a loan that does not call for annual payment of interest will be subject to annual imputation of income under the OID rules even if the interest rate satisfies the applicable safe harbor).

Although Dickman and Section 7872 generally kiboshed the more extravagant use of interest-free and below-market loans, practitioners who have unlocked the mysteries of Section 7872 (and its "sale or exchange" counterparts, Sections 1274 and 483) still routinely pick from a smorgasbord of strategies to exploit the arbitrage opportunity bestowed by Congress, namely, the fact that the AFR is generally lower than the prevailing market interest rate for the particular loan used. These uses include straightforward intra-family loans and installment sales, which may include loans from related trusts (e.g., from a bypass trust to a marital trust, or from a marital trust to a GST-exempt trust, to freeze the growth of the marital trust and transfer appreciation to the tax-advantaged trust) and more aggressive techniques such as installment sales to grantor trusts, which generally utilize the AFR rather than the higher Section 7520 rate.

III. THE FIRST HURDLE: IS THIS "LOAN" A GIFT?

A. The Bona Fide Loan Requirement

The threshold concern in the intra-family sale or loan context is ensuring that what the parties wish to characterize as a loan will actually be recognized by the IRS as such, rather than as an immediate gift of the entire principal.

Section 2501(a)(1) imposes a gift tax on the transfer of property by gift "by any individual, resident or nonresident." Although some courts²² and the gift tax regulations²³ stress that "gift" for gift tax purposes is not to be used in a colloquial, common law sense (i.e., requiring donative intent, as is required in the income tax realm under Section 102), the case law does not always bear this out. Although donative intent is irrelevant under the gift tax statutes in all but one limited circumstance,²⁴ as we will see, courts sometimes cannot resist the temptation to look beyond pure economics to the intent behind an intra-family transaction. This is understandable, in that the government presumes that a transfer of money from one family member to another is a gift.²⁵ The presumption may be rebutted by an affirmative showing that at the time of transfer the transferor had a real expectation of...