The United States Tax Court recently issued an important order involving the use of promissory notes in estate planning. Est. of Galli v. Comm'r, T.C., No. 7003-20 and 7005-20, illustrates that, in the context of loans in estate planning, the devil is always in the details.

In 2013, Barbara Galli transferred $2.3 million to her son, Stephen Galli, in exchange for an unsecured promissory note with a term of nine years. The note utilized the applicable federal mid-term rate of 1.01% in effect at the time. Mr. Galli made timely interest payments on the note annually, and Ms. Galli reported the note payments on her income tax returns as interest income. Ms. Galli passed away in 2016, prior to the expiration of the loan, and the unpaid portion of the loan was included as an asset on her estate tax return. The Estate also argued that the note should be discounted, but that was ancillary to the Tax Court's order.

The IRS issued a notice of deficiency for the nonpayment of gift tax and the underpayment of estate tax claiming this loan transaction lacked provisions necessary to create a legally enforceable right to repayment reasonably comparable to loans made between unrelated parties, and should have been reported on a gift tax return. As such, the IRS contended that there was an unreported and untaxed gift, resulting in an increased estate tax.

Mr. Galli timely filed petitions challenging the IRS's notice of deficiencies and provided clear evidence that the loan was properly structured.

The Tax Court analyzed the evidence presented by both the Estate and the IRS. The Tax Court ultimately disagreed with the IRS's position that the loan lacked provisions necessary to create a legally enforceable right to repayment. The Tax Court also noted that the IRS did not offer support for its position beyond the notice of deficiency itself.

The Tax Court emphasized the taxpayer's favorable evidence: the loan was properly structured with the appropriate interest rate, signed by both borrower and lender, contained a definite term, and that timely interest payments were made. The note contained the requirements of a valid loan agreement and was treated as a loan during Ms. Galli's lifetime.

In granting summary judgment in favor of the Estate, the Tax Court reiterated the importance of paying attention to the details of a promissory note to ensure the loan transaction contains the provisions necessary to create a legally enforceable right to repayment.

It is not unusual for a parent to make a loan to a child on terms more favorable than the child would get at a bank for instance. Such a note might have a lower interest rate, provide for interest only payments or a single balloon payment, and even be unsecured. It is easy for individuals to draft such a note without the most basic and minimal terms usually found in a note and to ignore the formalities of the transaction by skipping payments or failing to enforce the terms of the note.

The Estate of Galli shows that using the applicable federal rate, making payments due under the provisions of the note, having a specified term, and properly executing the note is vital for the note to be respected by the IRS. We recommend including the appropriate interest rate, the due date if it is not a demand note, right to prepay (even though the note in Galli did not include this language), remedies and/or penalties for failure to pay and security, if possible. 

After the note has been properly structured, the terms and formalities must be respected. The payments need to be made on a timely basis, and the recipient of the interest payments needs to recognize the interest income on their income tax return (assuming the interest payments constitute taxable income in the underlying transaction).

Barbara Galli did not report this loan on a gift tax return, as this loan was not a gift. However, in many cases it is appropriate to file a gift tax return and list the loan as a "transaction not a gift." By reporting the loan on a gift tax return, the IRS will have been notified of the transaction and the statute of limitations on reclassifying the loan as a gift begins to run.

Planning with promissory notes is not a new concept in the context of estate planning. The Tax Court's recent order underscores the importance of paying attention to detail, and treating a transaction as intended.