What Is an Intrafamily Loan?
Intrafamily loans, or loans between family members, can be an effective estate planning tool to transfer potential growth on loaned funds between generations without reducing the lender’s lifetime gift and estate tax exemption. The Internal Revenue Service (“IRS”) generally scrutinizes intrafamily loans and may recharacterize them as disguised gifts subject to gift tax. Therefore, it is important for intrafamily loans to be properly structured and administered. To learn more about intrafamily loans, click here to read an earlier advisory on this topic.
Valuable Insights From U.S. Tax Court: A Recent Case
A recent U.S. Tax Court ruling in Estate of Barbara Galli v. Comm’r, T.C. No. 7003-20 and 7005-20 (March 5, 2025) provided valuable insight on the Tax Court’s treatment of intrafamily loans. On February 25, 2013, Barbara Galli transferred $2.3 million to her son Stephen Galli and formalized such transfer in an unsecured 9-year term note with an interest rate of 1.01%. Although a 1.01% interest rate may sound low, this was in fact the mid-term federal applicable rate at the time. Under the note, Stephen was only required to make annual interest payments, and he made such interest payments as required in 2014, 2015 and 2016. The principal on the note was due to Barbara at the end of the 9-year term. On March 7, 2016, Barbara died with a taxable estate that included the unpaid portion of the note. Barbara’s estate discounted the unpaid note to reflect the risk of non-payment and reported it on the estate tax return as having a value of $1,624,000.
The IRS issued a notice of deficiency against Barbara’s estate for nonpayment of gift tax and underpayment of estate tax, arguing that the note lacked provisions necessary to create a legally enforceable right to repayment comparable to loans made between unrelated parties. Interestingly, unlike most intrafamily loan cases, in this case, the IRS did not claim that the note was a gift (and not a loan), but instead claimed that the note should be treated as a “partial gift/loan.”
The Tax Court disagreed with the IRS’s position. In its analysis, the Tax Court emphasized that the note was signed by both parties, included adequate interest under Section § 7872 of the Internal Revenue Code of 1986, as amended, and specified a repayment date. Additionally, Stephen made timely payments of all annual interest owed under the note and substantiated such payments with bank records. The Tax Court held that because the note was properly structured and administered, the note was correctly characterized as a loan, and not a gift or partial gift/loan. The Tax Court granted summary judgment for the nonpayment of gift tax and granted partial summary judgment for the underpayment of estate tax.
Takeaways
Barbara Galli v. Comm’r is a case of good facts and circumstances. If Stephen had not made timely payments on the note, the IRS likely would have argued that the note should be recharacterized as a gift. For example, in Estate of Bolles v. Comm’r, 133 AFTR 2s 2024-1235 (9th Cir 2024), the Tax Court recharacterized intrafamily loans as gifts because the Court determined that there was no evidence of repayment on the loans and the family member borrower had no ability to repay the loans. Both cases provide valuable insight into the Tax Court’s treatment of intrafamily loans and serve as a reminder of the importance of administering a properly structured loan according to its terms.
If you are considering an intrafamily loan as a tool in your estate plan, please do not hesitate to contact your Wiggin and Dana lawyer to discuss whether an intrafamily loan is appropriate to accomplish your unique estate planning needs and goals.