Category: Estate & Gift
Subject: Gift Tax
Title: Consequences of Loan Guarantee
IRC Sections: 2501
Filename: 1176.html
Date Produced: 9/96

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Taxpayer intends to guarantee bank loans made to his minor children. The loans facilitate various investments by the children, and the loans would not be made without the father's guarantee.

The issue is whether the guarantee is a taxable gift at the time it is entered into.

PLR 9113009 held that an arrangement such as is described above does give rise to a taxable gift at the time the guarantee is made. The ruling was highly criticized by the practitioner community and was later withdrawn without comment (PLR 9409018.

Clearly, the children benefit economically from this arrangement. Without the father's guarantee, the bank would not make the loan necessary to the investment program on which the father wishes to embark on behalf of the children. But the proper analysis for gift tax purposes is not whether the children have benefited. Rather, the proper analysis is whether the father has transferred a property interest to the children.

The gift tax is an excise tax imposed on the donor for the privilege of transferring property for less than adequate consideration in money or money's worth. The gift tax was enacted as part of the Revenue Act of 1932, the legislative history for which indicates that Congress intended the application of the gift tax to be comprehensive. The Committee Reports state that the term "property" reaches "every species of right or interest protected by law and having an exchangeable value" and that the term "transfer by gift" encompasses all transactions (except those specifically excepted) whereby "property or a property right is donatively passed to or conferred upon another, regardless of the means or the device employed in its accomplishment." The regulations provide that any transaction in which an interest in property is gratuitously passed or conferred upon another, regardless of the means or device employed, constitutes a gift subject to tax.

Notwithstanding the comprehensive nature of the gift tax and its broad definition of property, the donor must still transfer a property interest in order for the gift tax to be applicable. In Bradford v. Commissioner, 34 TC 1059, the taxpayer's husband was indebted to a bank. In order to avoid showing the debt for purposes of certain filings with the New York Stock Exchange (the husband's firm held a seat on the exchange), the taxpayer substituted her own notes to the bank for those of her husband. The court held that the taxpayer owned no property right with respect to the substitution of notes and could thus not transfer any right to her husband based on the facts at bar.

It seems to me that a loan guarantee is similar to the Bradford situation. A guarantee represents nothing more than a contingent obligation to transfer property in the future. Clearly, if the taxpayer were called upon to make good on his guarantee, there would be a taxable gift at that point. I would strenuously argue that there is no transfer of property until and unless that happens. After all, what property right is transferred as a result of loan guarantee. Even though there is an economic benefit, there is no property associated with it in my view.

Perhaps it could be argued that the taxpayer's borrowing capacity is a property right in and of itself, and since this capacity is diminished by the loan guarantee, there is a transfer of that property right to the children. This is really a legal question: is one's credit capacity a legally-protected, transferable property interest under the laws of the taxpayer's state? I am not an attorney and am thus not qualified to speak to this issue directly. I think it would be wise to consult a qualified attorney in your state. That notwithstanding, I would offer the comment that the idea that credit capacity is a transferable property right seems rather far-fetched to me. I suppose, however, there is a risk that a court could so hold at some point in the future.As far as advising the client is concerned, I think he should be told that this is a somewhat gray area, and the current interpretation of the law is that no gift occurs when a guarantee is made. On the other hand, the IRS has taken a contrary position in at least one situation, the private letter ruling discussed above, and could do so again in the future. In addition, the courts have been know to upset long-standing practices before, for example the landmark 1984 Supreme Court case of Dickman v. Comr., 465 U.S. 330, 84-1 USTC ¶9240. This case overturned the long-standing theory that an interest-free loan does not constitute a transfer of property and thus does not give rise to a taxable gift. This case was the impetus for the enactment in 1984 of IRC Section 7872.