Certain attributes of intra-family loans can present complex valuation issues that should be discussed with a qualified professional.

December 04, 2014

Intra-family loans can be very useful in many estate planning circumstances in light of the historically low current interest rate environment, but complicating issues can arise in structuring these transactions.  Many uses of intra-family loans take advantage of the artificially low applicable federal rate (“AFR”), which is typically significantly less than a commercially reasonable rate applicable in a Fair Market Value context, and can also be a source of controversy with the Service.  Past private letter rulings have taken the position that using an interest rate that is equal to or greater than the AFR will not be treated as a gift, simply due to the interest rate used(1). 

Under gift and estate tax regulations, the value of a note is the unpaid principal plus accrued interest, unless satisfactory evidence establishes that the note is worth less due to factors such as current market interest rates or a change in the creditworthiness of the borrower(2).

In the latest cases currently before the Tax Court involving intra-family loans (Estate of Donald Woelbing v. Commissioner (Docket No. 030261-13) and (Estate of Marion Woelbing v. Commissioner (Docket No. 030260-13)), the primary issue relates to the Service’s attack on the transfer tax planning technique in which taxpayers make installment sales to intentionally defective grantor trusts (IDGTs).  A sale to an IDGT will only be respected for estate tax purposes if the promissory note is treated as debt rather than equity.  Among the Service’s arguments is their claim that the installment note, which utilized the AFR in effect for the month of the sale, is not worth its face value because it carries an artificially low and commercially unreasonable interest rate.  Previous attacks by the Service have focused on whether promissory notes bearing interest at the AFR should be respected as debt in intra-family sales and whether these sale transactions are “bona fide transactions” for transfer tax purposes.

Intra-family loans, forgone interest, debt forgiveness, or a forgone or rescinded personal guarantee can trigger a gift tax, as it may be considered income to the recipient.  From an IRS perspective, personal loan guarantees may be considered a transfer of economic value.  The consequence may warrant a valuation of that specific attribute to determine Fair Market Value.  The value of a promissory note is typically determined based on the present value of the future note payments discounted at a market-derived rate of return.  The market yield applicable to the note is estimated based on the risk inherent in the investment and an assessment of the debtor’s underlying creditworthiness.

The IRS has provided guidance of the relevant factors to consider in determining the Fair Market Value of a note through Technical Advice Memorandum (“TAM”) 8229001, which include the following:

  • Presence of or lack of protective covenants in the note
  • Nature of the default provisions and default risk
  • Market for purchases and resale of the note
  • Financial strength of the issuer
  • Value of the security (i.e., the collateral) Interest rate and term of the note
  • Comparable market yields
  • Payment history
  • Size of the note

While most of the attributes of a note valuation may seem intuitive, certain attributes of intra-family loans can present complex valuation issues, such as the impact associated with a personal guarantee.  Empirical studies and market data are fairly limited as it relates to the specific valuation of a personal guarantee.  The appropriate methodology to apply will ultimately depend on the facts and circumstances of each case.  Refer to the article in the link below for additional insight on the valuation of intra-family loans and personal guarantees.

(1)  See Private Letter Rulings 9408018 and 9535026.
(2)  See Treasury Regulations Section 20.2031-4 and Section 25.2512-4.