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Gift Tax Effects of Substituting A Lower AFR Note for a Higher AFR Note
This article explores the gift tax consequences of an exchange of promissory notes between family members when interest rates have dropped from when the original or old note was
issue to the present time when the new note is issued. Specifically, it discusses the gift tax effects where a parent has loaned money to a child and the loan is evidenced by a promissory
note (“old note”) which provided at that time for adequate interest (i.e., interest at a rate equal or greater than the Applicable Federal Rate or AFR set by the Treasury Department) when it
is issued by the child. Under Code Sec. 7872, the value of this note was its face amount, as it bore adequate (AFR) interest when issued. However, Code Sec. 7872 does not determine that
note’s value at a later time, when the interest rates have gone down (or even if they have gone up or remained the same). At that time, Reg. § 25.2512-4 generally provides that the value of
the old note is presumed to be its face value. Therefore, if the old note is exchanged for a new note which provides for adequate interest (“new note”) and so would also be valued at face
under Code Sec. 7872, there should be no adverse gift tax consequences, as the notes exchanged have equal values: the old note likely will be valued at its face amount and a new note bearing
current AFR will be worth its face amount. Hence, each party will receive back in money or money’s worth an asset having a value the same as the one transferred. And when parties make such
an equal worth exchange, there can be no gift for Federal gift tax purposes.
Code Sec. 7872
Code Sec. 7872 provides for the treatment of loans with “below-market” interest rates. In the case of a demand loan (i.e., a loan payable on
demand), the loan is considered below-market under Code Sec. 7872(e)(1) if “interest is payable on the loan at a rate less than the applicable Federal rate”. In the case of a term loan (i.e., a loan payable at the end of a certain term), the loan is considered below-market under 7872(e)(1) if “the amount loaned exceeds the present value of all payments due under
the loan”. And the present value of the term loan is determined by comparison to one that bears the AFR). Hence, a term note that bears interest at the AFR is worth its face amount for
purposes of Code Sec. 7872 at the time it is issued. The AFR is established monthly by the Treasury Department based upon the rate “on
outstanding marketable obligations of the United States” or, in other words, what the Treasury pays in interest on obligations of the United States. AFRs are relatively low compared to
interest rates associated with commercially issued obligations, such as notes and bonds of which a corporation or a municipality or when an individual is the obligor.
Under Code Sec. 7872, in the case of any below-market loan that is a
“gift loan” or a demand loan, the forgone interest is treated as (1) transferred from the lender to the borrower, and (2) retransferred by the
borrower to the lender as interest. Under Code Code Sec. 7872(f)(3), a “gift loan” is any below-market loan where the forgoing of interest is in the nature of a gift. Hence, if the interest provided on what otherwise would be a gift loan is at least the AFR, there is no
forgone interest and the fundamental treatment prescribed by Code Sec. 7872 (that is, having interest treated as though it was transferred from the lender to the borrower—e.g.,
interest paid by borrowing child to lending parent—and then retransferred by the borrower to the lender—e.g.,
interest given back by the lending parent to borrowing child) does not apply. In other words, in the case of a note bearing at least the AFR at the time of its issuance, there is no gift tax
liability on the part of the lender.
Regulation § 25.2512-4
Although Reg. § 25.2512-2 provides a gift tax valuation method for debt obligations that
are publicly-traded, Reg. § 25.2512-4 provides the gift tax valuation rule for non-marketable bonds and notes (e.g., family promissory notes). This latter regulation states:
The fair market value of notes, secured or
unsecured, is presumed to be the amount of unpaid principal, plus accrued interest to the date of the gift, unless the donor establishes a lower value. Unless returned at face value, plus
accrued interest, it must be shown by satisfactory evidence that the note is worth less than the unpaid amount (because of the interest rate, or date of maturity, or other cause), or that the
note is uncollectible in part (by reason of the insolvency of the party or parties liable, or for other cause), and that the property, if any, pledged or mortgaged as security is insufficient
to satisfy it.
Declining Applicable Federal Rates
For the period from January 1989, through February 2003, the AFR with respect to midterm notes
with semi-annually compounded interest ranged from a high of 11.68% in May 1989, to a low 2.72% in May 2008. Currently, for June 2008, this rate is 3.17%.
Some Wealth Transfer Tax Planning Aspects of Promissory Notes
Because AFR interest usually is lower, and often much lower, than
returns available with investment opportunities in the marketplace (or outside of it), an opportunity to shift wealth free of gift, estate and generation-skipping transfer tax (collectively,
“wealth transfer taxes”) arises when one family member (such as a parent or grandparent) loans cash to another family member (such as a child or grandchild) at the AFR and the borrower invests
it in such a way that the return exceeds the AFR interest that borrower is obligated to pay on the loan. To the extent the borrower (e.g., the
child) earns more on the investment than the AFR interest the borrower must pay to the lender (e.g., the parent), the borrower acquires wealth
free from wealth transfer taxes. That may seem especially beneficial when the borrower makes the same type of investment that the lender would make: the inherent risk of the investment to the
family as a whole does not change and, if the return is greater than the AFR, that excess return is shifted, wealth transfer tax free, to another family member (such as a child or grandchild).
Raising Cash to Loan
In some cases, a family member may not have cash to loan. If that is the case, an alternative
is to have one family member sell an asset at its fair market value to another family member in exchange for a promissory note bearing at least AFR interest. By way of analogy to the Supreme
Court’s famous case, Dickman v. Commissioner, 465 U.S. 330 (1984), such a sale should avoid imputed “interest” or “rent”; however,the sale could result in gain. Nevertheless, taxation of the gain and any interest accrued or paid on the promissory note used to pay for the asset may be avoided if the
purchaser-borrower is a grantor trust with respect to the seller-lender. See Rev. Rul. 85-13, 1985-1 CB 184. That transaction is commonly known
as an installment sale to a grantor trust, an estate planning technique which became well-known in the late 1990s. The effect of grantor trust status is that the grantor, as opposed to the
trust, is primarily responsible for paying any tax on income generated by the trust. See Rev. Rul. 2004-64, 2004-27 IRB 7. Typically, a senior generation family member will sell assets to a trust, designed and administered to avoid the inclusion of its assets in the grantor’s gross estate for Federal
estate tax purposes but nonetheless to be a grantor trust with respect to the seller. The trust will generally be set up for the benefit of one or more members of one or more younger
generations of the grantor’s family, and the trust will give the seller a promissory note bearing AFR interest in return for the assets sold to it. To the extent the assets in the trust
appreciate or generate income at a rate greater than the interest which is owed to the seller, the trust for the younger generation family members will be able to meet their interest
obligations to the seller and “pocket” the profit free of income and wealth transfer taxes.
Effects of Note Substitution
The declining AFR may present an opportunity for family borrowers who issued promissory notes
and lenders who are holding such notes bearing interest higher than the current AFR. One option may be for the borrower simply to pay off the old (higher AFR) loan (plus accrued interest) and
then borrow again at the current (lower) AFR. If the borrower does not have the cash to do that, the borrower likely could pay off the note with non-cash assets. However, such a strategy
would result in gain recognition if the fair market value of the assets exceeds the borrower’s income tax basis, unless the borrower and lender are treated as the same taxpayer (such as is the
case with a grantor and a grantor trust) or another provision of the tax law would prevent the recognition of gain.
Alternatively, the lender may simply cancel the old note and accept in exchange a substitute
(new) note bearing a lower (but still adequate) AFR. In this case, the end result would be that that the lender simply accepted a new lower AFR note for the older higher AFR note. Thus, there
are open questions as to the tax effects, if any, of having the lender and borrower merely cancel the higher interest AFR note and issue (or substitute) a lower interest AFR note. The bottom
line, however, is that, although there is no case, ruling or Internal Revenue Code section that explicitly provides that promissory notes may be restated without gift tax effects, the Code and
regulations strongly support the conclusion that it possible to do so without a taxable gift being deemed to occur.
Determining the Value of Notes for Gift Tax Purposes
For purposes of Code Code Sec. 7872, as discussed above, a below-market loan is a loan payable
at a rate less than the AFR (which, in the case of a demand loan, is defined under Code Sec. 7872 as “the applicable Federal short-term rate in effect under Code Sec. 1274(d) for the period
for which the amount of forgone interest is being determined, compounded semiannually”) or a loan in which the amount loaned exceeds the present value of all payments due under the loan (in
the case of a term loan). As stated above, if the note bears at least AFR interest it is deemed to be worth the amount loaned—that is, its face amount. By definition, then, loans at (or
above) the AFR are not interest-free loans or below-market loans and, therefore, there is no taxable gift associated with a loan at an AFR based on the appropriate compounding period.
Hence, where a borrower's original note has adequate stated interest, if the borrower repays
the lender and takes out a second loan with adequate stated interest, it seems there should be no taxable gift at any point in this series of transactions. Accordingly, in the case of a
promissory note issued by a younger generation family member/purchaser to an older family member/seller, if that note bears interest at least at the AFR, there should be no gift tax
consequences or additional adverse income tax consequence to either party in making the loan or in repaying it. Moreover, as mentioned above, should the lender not have cash readily available
to loan, there would be no income tax consequence if the loan were through a sale of assets by a grantor (i.e., the lender) to a trust that was a grantor trust with respect to the grantor.
The analysis in the paragraph above, however, for purposes of potential gift tax due upon the exchange of the notes, also depends on how the old note is valued at the time of
substitution. Reg. § 25.2512-4, which seems to determine the fair market value of a note for gift tax purposes, presumes the old
note, at the time of substitution, has a fair market value equal to its face amount. And, perhaps more important, the regulation seems to allow variation of value only to establish it is
worth less than face amount. There is no indication that the IRS (or the taxpayer) is permitted to establish it has a
value greater than the face amount. Hence, even if the interest on the old family note is greater than current AFR and, it seems, even if the AFR on that note is greater than what the market
rate on such a note would be (e.g., the note bears 8% interest and the borrower-obligor could borrow from a commercial lender at less than that
rate), the note cannot be treated as having a gift tax value greater than its face amount.
For purposes of valuing the old note at the time of substitution, Reg. § 25.2512-4 (as opposed to Code Sec. 7872)
applies. There only a proposed regulation for gift tax purposes under Code Sec. 7872 (Prop. Reg. § 25.7872-1), which does not have the force of law. Also, that regulation seems only to
provide a rule for determining the value of a term loan at the time the loan is made, not when the note is retransferred (or paid off) and applies only to “Certain Below-Market Loans”. Moreover, a loan providing for interest at the
AFR is not a below-market loan and, therefore, the proposed regulation would not apply to such a note.
The Two Notes with Different Interest Rates Are Worth the Same for Gift
Tax Purposes
In conclusion, it seems nearly certain that a family note originally issued at the then prevailing AFR which is now higher than the current AFR has a fair market value for gift tax
purposes not greater than its face amount and is presumed to have a value exactly equal to it. Also, a note currently issued that bears current AFR has a value, determined under Code Sec.
7872, for gift tax purposes equal to its face amount. Hence, as the value of the old note is presumed to be its face amount at the time of substitution under Treas. Reg. § 25.2512-4, there should be no gift deemed made by the lender if a new note made by the borrower with a lower AFR is substituted for a pre-existing one
in the same face amount that bears a higher interest rate.
Gift from Borrower-Child to Lender Parent?
Perhaps, the foregoing principles on valuing family notes do not foreclose the IRS from arguing that the old
note (bearing higher AFR interest) is worth less than its face amount so that the borrower (e.g., a child) by issuing a new note bearing the
current, lower AFR (which, under Code Sec. 7872 principles, will be worth its face amount) is making a gift to the lender (e.g., the parent). In
other words, because Code Code Sec. 7872 and it proposed regulations only make an AFR note when issued equal to its face amount and a previously issued note is valued under Reg. § 25.2512-4 and might be proved to be worth less than face, a borrower who transfer a new AFR note (worth its face amount) in exchange for the
borrower’s old note could be treated as making a gift if that old note is worth less than face. But it seems highly unlikely that the IRS will take that position. Such a
position would seem to mean that a taxpayer could loan money to one child taking back an AFR note and then retransfer the note to another child claiming a gift tax value at less than its face
amount. That would open such an enormous opportunity for gift tax avoidance that it is inconceivable the Service would make the argument that an older family note bearing interest higher than
current AFR, even if the note cannot be prepaid, is worth less than face amount. Hence, it seems highly probable that substituting one family note for another AFR note cannot constitute a
gift for Federal gift tax purposes even if the older note bears interest greater than current AFR. |
