Are Advances to Children Loans or Gifts?

Overview

Often a parent (or parents) will advance money to a child.  The reasons for doing so are varied, such as making a large loan but then forgiving the payments each year consistent with the federal gift tax present interest annual exclusion (currently $15,000), but a significant question is whether such an advance of funds is a loan or a gift.  The proper classification makes a difference from a tax standpoint.

Is an advance of funds to a child a loan or a gift – that’s the topic of today’s post.

IRS Factors

The IRS presumption is that an advance is a gift when a transfer between family members is involved.  The taxpayer can overcome the presumption by showing that repayment was expected and that the taxpayer actually intended to enforce the debt.  In making that determination, the IRS utilizes a set of factors to evaluate whether an advance of funds amounts to a loan or a gift.  Those factors include whether the borrower signed a promissory note; whether interest was charged; whether collateral secured the indebtedness; whether payment was actually made; whether demand for repayment occurred when a payment was missed; whether there was a fixed due date for the loan; whether the borrower had the ability to repay the debt; how the parties characterized the transaction, and; whether the transaction was reported for federal tax purposes as a loan.  In essence, the question boils down to whether there is a bona fide debtor-creditor relationship. 

Illustrative Cases

In Miller v. Comr., T.C. Memo. 1996-3, the petitioners (a married couple) operated a ranch and employed their two sons to manage it.  One of the boys also managed his parents’ commercial property business in Georgia and that one of the sons helped manage.  The Mother transferred $100,000 to a son by giving him two $50,000 checks in the summer and fall of 1982.  She wrote the word “loan” on the check register and the check stub for each check and the checks were recorded in an account labeled “Notes Receivable – S. Miller” in the Mother’s general ledger.  She was trying to help him pay off a $56,000 mortgage on a house he and his wife bought in 1980 for $300,000 that became due in 1982.  In November of 1982, he used $56,000 of the $100,000 that he received from his Mother to retire the mortgage. The son signed a non-interest-bearing noted in the principal amount of $100,000 that was payable to his Mother.  The note was not secured by any collateral.   The note specified that the son was to pay his Mother on demand or three years after it was executed if no demand was made.  However, the Mother didn’t consider the three-year-later date to be a fixed date on which the son had to pay her, and she had no intention of demanding payment on that date, or any other date.  She also never discussed with her son any consequences of his failing to make payment.  In late 1982, the son made a $15,000 payment on the note, but didn’t make any more over the next three years.  The Mother never sought to enforce repayment, instead writing a “forgiveness” letter to him each year.  The IRS took the position (based on the multiple factors) that the loans were gifts.  The Tax Court agreed, which meant that the Mother had gift tax liability.  

In Estate of Bolles v. Comr., T.C. Memo. 2020-71, the decedent had five children and expressed a desire to treat them equally upon her death. She kept a personal record of advances to each child and any repayment that a child made. She treated the original advances as loans and forgave the “debt” account of each child annually in the amount of the federal gift tax present interest annual exclusion. The decedent and her spouse established a trust to hold some of their jointly owned property, including a substantial art collection and office building in San Francisco. At the time of her death she and her five children were among the beneficiaries of the trust. Her oldest child encountered financial difficulties and entered into an agreement with the trust to use trust property as security for $600,000 in bank loans. The son also owed the trust back-rent from his architecture practice. The son failed to meet the loan obligations and the trust was liable for the bank loan. The decedent transferred over $1 million to the son from 1985 through 2007. The son did not make any repayments after 1988. The decedent also had a revocable trust created in 1989. That trust specifically excluded the son from any distribution from her estate. It was later amended to include a formula to account for the “loans” made to the son during her lifetime.

Upon her death, another son filed a federal estate tax return and the IRS determined a deficiency of $1,152,356, arguing that the decedent’s advances to the oldest child were taxable gifts and not loans. The Tax Court determined that the amounts were gifts based on a non-exclusive, nine-factor analysis used in determining the status of advances: (1) whether there was a promissory note or other evidence of indebtedness; (2) whether interest was charged; (3) whether there was security or collateral; (4) whether there was a fixed maturity date; (5) whether a demand for repayment was made; (6) whether actual repayment was made; (7) whether the transferee had the ability to repay; (8) whether records maintained by the transferor and/or the transferee reflect the transaction as a loan; and (9) whether the manner in which the transaction was reported for Federal tax purposes is consistent with a loan.

The court determined that the decedent did not have a reasonable expectation of repayment due to the son’s financial situation and employment history. However, a small portion of the advances made to the son while his financial situation was more favorable were loans because the decedent could expect repayment based on the son’s improved financial condition. The Tax Court noted that with respect to situations involving loans to family members, an actual expectation of repayment and an intent to enforce the debt are critical to sustaining the tax characterization of the transaction as a loan. 

Conclusion

Be careful when making loans or gifts to children.  Take care to document the transaction(s) carefully and make sure to structure it with the factors listed above in mind to achieve the desired result.  Also, be mindful of another weapon the IRS might utilize in certain transactions, including those involving family members – the “step-transaction” doctrine.  This is another potential problem that can arise when the gift/loan distinction is not in issue.  For example, in Estate of Cidulka v. Comr., T.C. Memo. 1996-149, the IRS successfully utilized the doctrine to trigger gift tax liability.  The decedent had made annual gifts of stock during his life to his son, daughter-in-law and grandchildren.  He treated the transfers as gifts for gift tax purposes and kept each one at or under the applicable gift tax present interest annual exclusion (currently $15,000) so that he wouldn’t have to pay gift tax on the transfers.  Over a 14-year period, the daughter-in-law dutifully transferred her gift each year to her husband (the decedent’s son) on the exact same day her father-in-law transferred the stock to her.  The IRS didn’t have trouble picking that one apart.  It took the position that the annual gifts to her were really for her son, exceeded the annual exclusion amount and were subject to gift tax. 

Transferring funds to children can be full of traps.  Be advised.