For many individuals, ensuring the family business remains solvent is of utmost importance. Depending on the family’s enterprise, loans between family members may be required during turbulent financial times to keep the company afloat. In a ruling released on April 1, 2024, the U.S. Court of Appeals for the Ninth Circuit affirmed a Tax Court ruling that scrutinized one series of intrafamily “loans” and held that although some transfers in question could be characterized as loaned amounts, subsequent transfers must be treated as gifts based on the intent and the actions of the “lender” and the “borrower” (Estate of Bolles v. Commissioner, No. 22-70192, 2024 WL 1364177 (9th Cir. April 1, 2024)).
History of “Loans”
Peter Bolles was the oldest of five children of Mary and John Bolles. He graduated with a degree in architecture in 1965, and based on his academic achievements and his father’s reputation as an architect in San Francisco, he showed great promise. After working for some time in Boston, he would later move home to San Francisco, where he took over his father’s practice. Despite such promise, he began to have financial difficulties in the mid-1980s.
From 1985 through 2007, Mary transferred a total of $1,063,333 through a series of payments to or for the benefit of Peter to assist him with the family business. While he initially made some payments on the “loans” (none of which were evidenced by a promissory note), Peter ceased doing so after 1988.
Accordingly, in her revocable trust dated Oct. 27, 1989, Mary excluded Peter from any distribution of her estate on her death. In a subsequent amendment to the trust agreement, instead of excluding Peter entirely, Mary provided a formula for the distribution of her property on her death to essentially equalize the other trust beneficiaries for the unpaid “loans” made to Peter during her lifetime. In May 1995, Peter signed an acknowledgment, noting that he, as of that date, had received $771,628 and, although he had neither the assets nor the earning capacity to repay all or any part of the amount so “loaned,” such amount, together with interest, would be utilized in calculating the division of Mary’s trust assets on her death. Beyond this acknowledgment, Peter never delivered a promissory note or other evidence of indebtedness to his mother.
After Mary’s death, her executor filed an estate tax return which described Peter’s signed acknowledgement as a “[p]romissory note dated May 3, 1995, in the face amount of $771,628” that “is wholly uncollectible and worthless” because “Peter P. Bolles is insolvent.” The estate tax return also failed to report the additional amounts transferred to or for Peter’s benefit as gifts made to him during Mary’s life. After reviewing the estate tax return and the history of payments, the Internal Revenue Service disputed how the transfers from Mary to Peter were reported on the return and sent Mary’s executor a notice of deficiency, claiming: (1) if any amounts were loans, the return needed to account for any outstanding amounts by adding them to the gross estate, and (2) if any amounts were gifts, the return would need to reflect such amounts as “prior gifts.” As the parties were unable to come to an agreement as to which payments were loans and which payments were gifts, the executor resorted to the Tax Court to resolve the issue.
Distinguishing Advances as Loans or Gifts
There are traditional factors, known as the “Miller” factors, which are used to determine whether an advance of funds from one individual to another should be deemed a loan or a gift, including whether: (1) there was a promissory note or other evidence of indebtedness; (2) interest was charged; (3) there was security or collateral; (4) there was a fixed maturity date; (5) a demand for repayment was made; (6) actual repayment was made; (7) the transferee had the ability to repay; (8) the transferor maintained records; and (9) the manner in which the transaction was reported for federal tax purposes is consistent with a loan. (Miller v. Commissioner, T.C. Memo 1996-3, aff’d. 113 F.3d 1241 (9th Cir. 1997)).
In the context of intrafamily loans, even more scrutiny is applied to a transaction to determine whether the amount so transferred is a bona fide loan or is, in fact, a gift. It’s a longstanding principle that 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. (Estate of Van Anda v. Commissioner, 12 T.C. 1158,1162 (1949), aff’d per curiam, 192 F.2d 391 (2d Cir, 1951)).
In the litigation at hand, the Tax Court held, and the Ninth Circuit affirmed, that the payments from Mary to Peter from 1985 through 1989, notwithstanding the lack of promissory notes, were loans because the circumstances indicated that a bona fide creditor-debtor relationship existed between them. It took nearly a decade for Peter to run into financial troubles after he entered the workforce, and Mary, who was previously married to an architect, knew there were fluctuations in the financial fortunes of the practice. It was reasonable then that, during this time, Mary expected Peter to use the payments to make the business successful and repay her once the practice became solvent again.
The payments after 1989, however, were made under different circumstances: no repayments to Mary were made by Peter during this subsequent period, Peter was specifically excluded from Mary’s estate plan in late 1989, and Peter had signed the acknowledgment stating that he had neither the assets nor the earning capacity to make any repayments. The Ninth Court affirmed the Tax Court’s conclusion that no bona fide creditor-debtor relationship existed after 1989 based on these facts and, accordingly, each payment during this subsequent period was, indeed, a gift.
The facts made clear that Mary had high hopes for her son when she began transferring money to him to support his professional work. However, it was also clear that, at least by Oct. 27, 1989, Mary realized Peter wouldn’t be able to pay her back, causing her to revise her estate plan to remove him as a beneficiary. Accordingly, as of that date, subsequent transfers couldn’t continue to be treated as loans and would be required to be treated as gifts for federal tax purposes.
Prepare for Scrutiny
Practitioners who become aware of an intrafamily loan, either because they’re asked to assist directly or learn of the loan in their dealings with a client, must advise their clients to ensure that all parties to the transaction conduct themselves as if it were a loan. If the facts don’t support bona fide lending, an unintentional gift may be completed and, depending on the amount of the “loan,” serious financial consequences may result from the transaction. The IRS’ position in this case is one that’s been advanced frequently in the last few years – intrafamily transactions will be scrutinized more closely in determining gift/estate tax issues and deficiencies. As a result, practitioners must scratch beneath the surface of the transaction to ensure the elements of a bona fide loan are present if the parties desire to avoid gift treatment.