Monday, March 06, 2006

Some Initial Tax Analysis

Note: The following is meant for my own educational purposes only and is not intended and should not be taken as legal advice. Acting on any legal analysis contained within is done at your peril. Filing incorrect tax returns can result in fines and even jail time. Also, the following may be boring for people who aren't interested in federal income tax.

I have spent the past week or so delving deep into unexplored regions of the tax code, treasury regulations, and tax court cases in order to figure out the proper tax treatment of the following hypothetical situation:

Taxpayer A (TPA) is the parent of Taxpayer B (TPB). TPA is in the habit of giving as a gift $10k a year to TPB, because TPA loves TPB and wants TPB to be able to buy groceries during a time of TPB's life where TPB has no income and considerable expense. It comes to pass that TPB need a new car, but needs something with some hauling capacity and thus needs a minivan. But a minivan costs $30k. TPA doesn't want TPB to have to get a loan from the dealer at a high interest rate (nor could TPB get a loan with no income). So TPA lends TPB $30k with the understanding that the loan will be paid back at a rate of $10k per year by way of TPA simply not giving TPB the usual $10k gift and instead applying that amount to the outstanding loan.
That's the hypo.

So now some background. The tax code provides that a donor (gift-giver) can give up to $10k dollars per year per donee (gift-getter) without being subject to the gift tax. However, if the donor gives more than $10k in a year to a single donee, then the donor has to pay the gift tax on the amount of the gift exceeding $10k. So we can see that TPA does not want this loan reclassified by the IRS as a gift.

However, the IRS has in the past reclassified intra-family loans as gifts. The most common case where this happened prior to 1984 was in no interest (or below market interest) demand loans. A demand loan is a loan with no specified repayment date that the lender can demand be repaid at any time (presumably a parent would exercise this power sparingly). The service (with approval of the courts) would reclassify the loan as a gift in the amount of the present value of the use of the loan money. This is kind of a weird distinction, but those of you who have finished your first year of law school and remember from the analogy of property rights as a bundle of sticks may understand. The IRS considered that the donor gave and the donee received a property right in the use of the loan money at less than fair market interest rates. So the amount that would be considered a gift of property is less than the actual amount loaned, but how much less is beyond my mathematical abilities.

In 1984, following a Supreme Court decision (Dickman v. Comm'r, 104 S. Ct. 1086) (the opinion was written by Burger and isn't much of a read, but the dissent was written by Powell (Rehnquist joining) and is a good read and fairly persuasive) approving of the above treatment of below market loans, Congress codified and slightly broadened the Court's holding by enacting section 7872.

Section 7872 says that any below market loan which is a gift loan or a demand loan will be considered a gift to the extent of either (1) the foregone interest on the loan or (2) the excess of the amount loaned over the present value of all payments which are required to be made under the terms of the loan. To check out the full text of the section, click on the US Tax Code link on my side bar.

So back to our hypo. In our case the first of the two treatments under the previous paragraph would apply, but for 7872(d)(1), which swoops in to save the day for our taxpayers. Said subsection provides that 7872 will not apply to loans that do not exceed $100k. Our taxpayers' transaction escapes the gift tax, to the detriment of society which is deprived of much needed revenue for social programs.

As a side note, the loan between TPA and TPB should be evidences by a writing which provides for a date of repayment.


Anonymous Anonymous said...

The real question is how can TPA get a car and still receive 10K a year from TPB?

10:13 AM  
Blogger Fishfrog said...

Well, that's a problem. If TPA gives TPB the loan and sets the repayment date for three years later, and then proceeds to reduce the balance on the loan by $10k, that $10k reduction is treated as income to TPB to the tune of $10k. Because it's a gift, though, it is taken care of by the $10k allowance for gifts. However, if TPA gives TPB $10k cash in addition to reducing the outstanding debt by $10k, TPA has effectively given TPB $20k in gifts for the year. TPA would have to pay gift tax on the excess $10k. If TPB were married, though, TPA could give $10k to TPB's spouse while forgiving $10k of TPB's debt with no tax consequences to anyone. The lesson: get married.

11:40 AM  
Anonymous big brother said...

Are you and nell buying a new car

6:51 PM  
Blogger Fishfrog said...

No. We're quite content with the CRV. A friend just asked me about a hypothetical situation and so I naturally sought to answer it fully.

7:10 PM  
Blogger Xeno said...

Ow, my brain! Get away! Ahhhhhhhhhh!!!!11!!!one! The taxes! THE TAXES!!!!!

8:32 PM  

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