It Looks Like a Loan, Quacks Like a Loan, But Do You Really Want it to be a Loan?

Background

When a benefactor, say a parent, loans an heir, say a child, funds, historically that transfer would have generally been desirable to treat as a loan. If the transaction were not a loan, then the parent would have made a taxable gift to the child triggering a potentially significant gift tax cost.  There are a plethora of cases addressing the validity of loans. See for example, Miller v. Comr., 71 TCM 1674 (1996), aff’d 113 F.3de 1241 (9th Cir. 1997); Santa Monica Pictures, LLC v. Comr., 800 F2d 625 (6th Cir. 1986). For wealthy taxpayers that continues to be the case and both taxpayers and their advisers need to pay carefully attention to the requirements to assure that the transfer is respected as a loan. The checklist and comments below as to factors to consider will be useful to guiding such taxpayers.

For the vast majority of taxpayers the estate tax is no longer relevant in light of the new $5 million inflation adjusted exemption. The law concerning the validity of loans developed in an environment when taxpayers sought loan treatment, while the IRS argued for gift characterization. So what becomes of this legacy in our new Alice in Wonderland tax world? Should the taxpayer want the transfer to be treated as a loan or as a gift? The answer is found in the tax version of the famous candy bar jingle: “Sometimes you feel like a loan. Sometimes you don’t. Peter Paul Almond Joy’s got loans. Mounds don’t.”

The New Loan Paradigm

In the new tax environment clients of “moderate” wealth (moderate relative to the high exemption amounts) might take a view of their transfers differently then what had been done in the past. Bear in mind, in this new tax world a $10 million net worth for a family is “moderate” for tax purposes.  Planning may follow the lines of the character from the movie Little Big Man, Younger Bear, who became a contrary, a tax-warrior who does everything in reverse.

Contrary Loan: If parent loans child money and that transfer is treated as a loan, interest may have to be paid which will have income tax consequences. The interest expense might not be deductible by the payor child (e.g., it doesn’t qualify as a home mortgage indebtedness) but yet might nonetheless be taxable as income to the parent/lender. That whipsaw is not a pleasant tax result. Perhaps the parent takes the IRS’ historical role on audit and argues that the transfer was not in fact a loan, but rather a gift, because it failed too many of the characteristics required to constitute a loan. As a gift the interest imputation rules are irrelevant and the negative income tax whipsaw might be negated.

Silver Divorce: Divorce of the over 50 crowd is growing rapidly. In 1990, fewer than 1 in 10 persons who divorced were over the age of 50. In 2104 one fourth of those divorcing were 50 or older. Jaffe, Ina “Older Americans’ Breakups Are Causing A ‘Graying’ Divorce Trend”, Feb 24, 2014 at http://www.npr.org/2014/02/24/282105022/older-americans-breakups-are-causing-a-graying-divorce-trend . Mom and dad are getting divorced. Transfers were made to the children. If those transfers were loans they remain an asset of the marital estate. If they were gifts they do not. In the past there might have been a significant negative gift tax cost to arguing for gifts instead of loans. For most taxpayers that will not be irrelevant. Might a parent use the traditional checklists of loan factors to argue that the transfer was a loan?

The new and often opposite tax objectives might suggest rethinking many transactions. Existing “loans” should proactively be revisited and evaluated for what the desired and appropriate treatment might be.

Factors Indicating The Transfer is a Loan

Factors that suggest the validity of the transfer as a loan may include the following:

• A written promissory note or other evidence of indebtedness.
• Interest was charged.
• Security or collateral for the debt. While the loan instrument itself might recite that it is secured, it would be preferable/stronger if in fact a lien, mortgage or other instrument corroborated that security interest.
• Fixed maturity date.
• A demand for repayment was made once the maturity date occurred.
• Actual payment was made of interest and principal when due.
• Transferee had the ability to pay. Likely this test should be applied at inception when the loan was first advanced.
• The records retained by the transferor and transferee reflect the transaction as a loan. For many taxpayers this is limited to income tax returns. Gift tax returns, financial statements, reports to third party lenders and other documents might also corroborate that the transaction was reported as a loan.
• The transaction was reported for federal income tax purposes as a loan. For individual taxpayers this might be reflected in interest income on Schedule B for the lender, as an example.
• If an entity is involved there is no perfect correlation or identity of interest between the creditor and equity holders.
• Ability to obtain financing from an outside lender on similar terms.
• Repayment was not unreasonably subordinated to the claims of outside creditors.
• Extent to which loan proceeds were used to acquire capital assets of long term value.
• Adequacy of capitalization of the borrower. Many tax practitioners use the mythical 10% equity test for this analysis.
• The “payments” made to the borrower should not reasonably be recharacterized as salary, dividends, other distributions, etc.

Factors Indicating The Transfer is a Loan

Factors that suggest the validity of the transfer as a loan may include the following:

• There is no written promissory note or other evidence of the debt created.
• Interest was not charged or if charged inadequate.
• Interest, however assessed, was not paid, or at least not paid regularly, timely or in conformity with the requirements of the purported loan, or was paid by an inappropriate party (i.e., anyone other than the stated borrower).
• There is no security or collateral for the debt. This could mean that the note instrument does not recite security or if it does that the underlying legal documentation to corroborate that security was never prepared.
• There is no fixed maturity date for the purported loan.
• No demand for repayment was made when due.
• Actual payment was not made on maturity.
• The transferee or purported borrower did not have the ability to repay the loan when made
• The records retained by the transferor and transferee do not reflect the transaction as a loan. For many individuals, especially if the purported loan was made without professional guidance, documentation is abysmal or non-existent.
• The transaction was not reported for federal income tax purposes as a loan.
• Identity of interest between the creditor and equity holders.
• The borrower did not reasonably have the wherewithal to obtain financing from a third party lender on similar terms. This is a particularly interesting factor in that loans at the minimum rates required by the tax laws are almost invariably less than what third party lenders would accept.
• Repayment was subordinated to the claims of outside creditors.
• The borrower does not have adequate capitalization to support the loan.
• No loan documents were created and no interest was paid.
• The payments might be recharacterized as salary, dividends, other distributions, etc. If the loans were actually salary then past due payroll and income taxes, interest and penalty charges could be paid to corroborate the recaharcterization.

Conclusion

As with so many areas of tax law, the dramatic changes in estate and income tax in recent years have flipped traditional planning assumptions upside down in many instances. Taxpayers and their advisers should all be cautious about making assumptions based on what they have traditionally done. In some instances the opposite approach may be justifiable and preferable.