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Tax Court Sides With Estate in Note Valuation Judgment

Tax Court Sides With Estate in Note Valuation Judgment

Estate of Barbara Galli, Deceased, Stephen R. Galli, Executor, et al., Petitioners, v. Commissioner of Internal Revenue, Respondent

Key Takeaways

The Court reaffirmed that a promissory note bearing interest at the Applicable Federal Rate is not a below-market loan and does not trigger gift tax under IRC § 7872.
Proper documentation, consistent payment history, and borrower solvency were critical in establishing the note as a bona fide, enforceable debt.
The IRS failed to convince the Court that a discount at death necessarily implies a gift at issuance, rejecting its valuation consistency argument.
Discounted cash flow analysis remains a valid method for valuing notes for estate tax purposes under § 20.2031-4.
Although the taxpayer prevailed, the Court left unresolved, albeit unlikely, the broader question of mandatory valuation consistency across gift and estate tax regimes.

BY Carsten Hoffmann

January 07, 2026

In 2017, FMV Opinions, Inc. (since then FMV has merged with Stout) was asked to value a note receivable held by the Estate of Barbara Galli, who had passed in 2016. FMV concluded the fair market value of the note to be $1,624,000, a discount of 29% to the face value of the note of $2,300,000. Determining the fair market value of a note receivable for estate tax purposes is standard practice and in line with section 26 CFR § 20.2031-4, which calls for the fair market value of a note to be the unpaid principal plus interest unless the executor determines the note is worth less than said amount. The note in question was issued at the Applicable Federal Rate (AFR) at the time of issuance of 1.01%. As set forth under IRC § 7872, which governs what interest rate is treated at a below market rate, the note did not give rise to any gift tax consequence given the use of the AFR rate.

This set the stage for the classic whipsaw that the IRS has battled for many years. How can it be that the same note that was worth $2.3 million is suddenly worth $1.6 million? The IRS believes that either there was a gift upon issuance, or the discount at death is illusionary. In the summary judgement of the Estate of Barbara Galli, these two worlds would clash again.

Summary of Facts

The note was issued on February 25, 2013, between mother and son and as of the date of death had an outstanding balance equal to the issuance amount of $2,300,000, plus interest accrued. The terms of the note required annual payments of interest only in the amount of $23,230 calculated at 1.01% per annum until paid maturity on February 25, 2022. The nine-year note was unsecured and as of the valuation date all required payments of interest had been made by the borrower on a timely basis. The assets of the borrower were significantly more than the amount owed, and the borrower presented a low credit risk.

FMV Opinions/Stout valued the note using the discounted cash flow approach and determining the appropriate discount rate by way of a build-up method utilizing the guidelines presented under Technical Advise Memorandum 8229001. FMV Opinions/Stout considered the protective covenants of the note, the default risk, the available market for resale, the financial strength of the issuer, the value and type of security (or lack thereof), the interest rate and terms of the note, and the payment history of the note. Either adding to the appropriate base yield or subtracting from the base yield for the above listed considerations resulted in a concluded discount rate of 7.25% and the concluded value of $1,624,000.

The IRS Argument

The IRS quickly recognized the futility of challenging an FMV Opinion’s/Stout’s fair market value determination of the note (a characterization offered with tongue firmly in cheek). Instead, the IRS focused on a legal argument that addresses what the IRS considers the whipsawing between § 7872 issuance and § 2031 death value of the note.

The IRS had issued deficiencies in both the gift tax and estate tax cases, arguing in essence that the transaction was at least a partial gift because the note was unsecured, allegedly lacked commercial enforceability, and raised questions about repayment intent. The IRS further suggested that the “difference” between the $2,300,000 note and the estate’s later reported fair market value of $1,624,000 represented an unreported gift, as it invoked valuation consistency and duty‑of‑consistency themes to align gift and estate tax treatments. In the alternative, the IRS argued the estate should value the note using only time‑value discounting at the applicable federal rate, mirroring the gift‑tax position that no gift occurred in 2013.

The Taxpayer’s Argument

The taxpayer’s legal counsel, not burdened with defending valuation issues, focused on the rebuttal of the legal arguments put forth by the IRS. The taxpayer’s defense for the legitimacy of the note transaction rested on the following primary arguments, discussed below.

The estate argued that because the note used the IRS mid-term AFR of 1.01%, it satisfied § 7872. They contended that under this statute, a loan bearing interest at the AFR is not a “below-market loan” and cannot be recharacterized as a gift.

Taxpayer counsel also presented a written, signed promissory note dated February 25, 2013, as evidence of a legally enforceable obligation with the borrower making timely payments of all interest due and the lender reporting those payments as income from a loan on her tax returns.

Lastly, the taxpayer was able to defend the commercial standard argument by providing proof of the solvency of the borrower while pointing out that lack of collateral does not invalidate the legality of the note.

Conclusion of Findings

Turning to the law, the honorable Judge Holmes held that IRC § 7872 governs below‑market loan characterization and that charging at least the AFR removes the transaction from “below‑market” status, and therefore no gift arises under § 7872.

Citing Frazee, the Court emphasized that Congress displaced traditional fair market value methods for gift tax purposes with the § 7872 discounting framework. The Court further pointed out that the note was properly documented and had a history of payments, contrasting this decision with the 2024 decision in the Estate of Bolles v. Comm’r, 133 AFTR 2d 2024-1235 (Ninth Cir. 2024), in which some loans were reclassified as gifts because there was no evidence the borrowing family member made any repayments and there was evidence he had no ability to repay those loans. The Court granted the taxpayer summary judgment in the gift‑tax case and partial summary judgment in the estate‑tax case.

While the taxpayer here achieved a victory with the summary judgment on this gift tax issue, there’s an outstanding issue the Court didn’t address: whether the estate can discount the value of the loan for estate tax purposes. The Court rejected the IRS argument that a discount upon death requires a discount upon gift (or sale).

However, the Court left open the door on the highly unlikely argument that if the fair market value for gift tax purposes is the full outstanding debt undiscounted, then that should be the valuation conclusion for estate tax purposes. This would require ignoring fair market value concepts set forth under § 20.2031-4. IRS proposed regulation 20.7872-1 suggests a duty of consistency by requiring that any loan made with donative intent be considered for estate tax purposes in a manner consistent with its treatment for gift and income tax purposes. The proposed regulation has not been finalized and, given it was introduced in 1985, nobody is holding their breath.

Lessons Learned

Prior court cases are always used as “guidance” only because the fact pattern of each can be unique enough where the result matters but should not be viewed as definitive. This case focuses very specifically on the long-belabored whipsawing between § 7872 defining below market loans and fair market value for estate or gift tax purposes. The verdict reached by the Court in their summary judgement is clear: the IRS will have to change the statute if they expect a different result.