Loan or Gift

[Donanita]

I have a client who loaned their son money to pay off his medical & dental bill. Client had loan agreement drawn up which son signed agreeing to make payments of $100 a month until the loan was paid off. Son has filed bankruptcy and named parents in bankruptcy.Client wants to know is loan will be deductable as bad debt or would the IRS consider the a gift even though son signed a loan agreement.

[Bjorn]

Loan

The son had a legal obligation to pay them back and the debt was worthless. That sounds like a nonbusiness bad debt ~ short term cap loss in the year it is worthless.

QF suggests a formal demand for payment and a response from debtor stating he cannot pay because he is bankrupt.

Think twice before lending kids money. If the bank won't touch them there very well may be a reason.

Perhaps others would like to ad to this.

[Bird Legs]

Loan or Gift

Since a note agreement was drawn and signed, agreeing to pay back the money, would be considered a loan. Especially since it was placed in bankruptcy.
If this was a gift, then there would have been no need for the note to go into the bankruptcy. You do not repay a gift.

[jimmcg]

Loan v Gift

A note agreement was signed and a payment schedule documented. This would establish intent. In addition the Federal court discharged the loan in bankruptcy. Should be pretty academic in establishing this as a loan. Sounds like a personal bad debt subject to short term capital loss limitations.

[Armando Beaujolais]

I'd agree that it may look at face value like a bad debt. Evidenced by a note, legally enforceable, discharged in bankruptcy? No, just named.

Think about all the "loans" parents make to their kids that don't get paid back. I don't believe that a signed note would have nearly as much weight as other facts and circumstances.

Not knowing all the details I'd be a bit concerned about the true debtor/creditor relationship. Did the son have the means to pay back the loan when the agreement was reached? Did the parents have confidence that the loan would be paid back? There has to be some semblance of an arms length transaction, a substance over form deal. Also, there have to be efforts made to collect the debt. What efforts were there?

If the parents had reason to believe there was a fair likelihood that the son would have problems paying off the loan, I'd expect it to be thrown out at audit and more importantly, appeals. Would they have made the loan to, say, their next door neighbor's kid?

What changed with the son between the time the "loan" was made and the time the bankruptcy occurred? If there was no unforseen change in circumstances, considering the parents likely knew what those circumstances were with the son teetering on bankruptcy, I don't see a signed note or a declaration of bankruptcy changing the substance of the transaction.

If the loan was made only because it was their kid and they wanted to help out, if the parents wouldn't have made a similiar loan to an unrelated party, and if an unrelated party would not have made the same loan to the son, signing a piece of paper doesn't establish intent. I'd even question whether being discharged in bankruptcy would hold any weight, although it may be a small factor.

[Donanita]

Loan

Yes the parents made th loan in good faith that the son would repay. Son had a job at the time and did make some payment on the loan. Parents were send papers from the bankruptcy court so they have evidence they were listed. No,parents had no idea of son's financial situation as the son was in his 30's. I thought this would be a nonbusiness bad debt but wanted other feedback before I contact client.

[jimmcg]

Loan

Still feel confident I could get this past the audit or appeals level as a non business bad debt.

[Armando Beaujolais]

Yes the parents made th loan in good faith that the son would repay. Son had a job at the time and did make some payment on the loan. Parents were send papers from the bankruptcy court so they have evidence they were listed. No,parents had no idea of son's financial situation as the son was in his 30's. I thought this would be a nonbusiness bad debt but wanted other feedback before I contact client.

From the additional more complete information, the situation looks more like a true debtor/creditor relationship.

Notice that the regs talk about a substantive transaction "evidenced" by a signed note. The important part is the substance of the transaction. A signed note is evidence of the nature of the transaction. A signed note does zero to create substance of a transaction.

It's no different than when sole proprietors asks a practitioner the question "Do I have to report this income?"

Some practitioners may answer "Was it reported to you on a 1099?"

That's the wrong answer.

[Armando Beaujolais]

To hopefully go beyond shooting from the hip and better illustrate the point I’m trying to make.

Fuhrman, Tax Court Memo 1959-81

“The petitioner must show that at the time money was advanced there was an intention to make a loan and that there was no intention to make a gift, i.e., that a debtor-creditor relationship existed. Jacob Grossman (Board of Tax Appeals);”

From the Grossman decision:

“Transfers of money from a father to a minor son cannot create a debt. Transfers from a father to an adult son may; but only by an express agreement to that effect. Presumptively such transfers are irrevocable gifts, either never to be accounted for or only as advancements.”


A transfer of money from a parent to a child is “presumptively” a gift. The burden is on the taxpayer to prove that a “debtor-creditor relationship existed.”

In this case, if the parents had reason to believe the amount could and would be paid back, it looks like a bona fide loan to me. The signed document is evidence of the substance of the transaction.