In March 2025, the U.S. Tax Court delivered a pivotal ruling in Estate of Galli v. Commissioner (T.C. No. 7003-20 and 7005-20), establishing that a $2.3 million transfer from a mother to her son was a legitimate loan—not a gift—because it adhered to the criteria set forth in Internal Revenue Code § 7872. Although this decision might encourage making large intrafamily loans at the Applicable Federal Rate (AFR), it underscores a more critical lesson: the significance of formalities, documentation, and intent in structuring loans.
If you are considering extending a loan to a child, grandchild, or trust, Galli serves as both a cautionary tale and a guidepost.
Why Galli Matters: Form Over Affection
In Galli, the IRS argued that the $2.3 million transfer was a disguised gift due to its informality and potential unenforceability. However, the Tax Court disagreed, citing a signed promissory note, interest charged at the mid-term AFR, annual interest payments, and proper tax reporting, thereby upholding the transaction as a loan.
Contrast this with Miller v. Commissioner, where transfers were deemed gifts because of a lack of documentation, interest payments, or enforceability. Galli prevailed by satisfying both the form and substance of a bona fide loan, even within the inherently informal context of family transactions.
Beyond the AFR: Fiduciary Duty and Trust Loans
A common misconception from Galli is that AFR compliance is universally sufficient. This is not the case. When an irrevocable trust lends to its grantor or a non-beneficiary, the AFR may not fulfill fiduciary standards. The Restatement (Third) of Trusts mandates that trustees act solely in beneficiaries’ interests.
As highlighted in Estate of Vincent J. Duncan, Sr. v. Commissioner, using market-based interest rates (e.g., 6.7%) is more appropriate for fiduciary compliance. Merely charging AFR could expose trustees to liability for imprudent lending, even if it satisfies gift tax requirements.
Conclusion: When Sentiment Meets Structure
Intrafamily loans are powerful tools in estate planning, facilitating wealth transfer, liquidity management, and intergenerational support. Yet, as Galli illustrates, good intentions are not sufficient. Structure, documentation, and execution are crucial. When these loans involve fiduciary duties—such as loans from trusts—market discipline becomes even more essential.
Checklist: Essential Documents and Formalities for Intrafamily Loans
- Promissory Note: Clearly outline the loan amount, interest rate (at least AFR), maturity date, and repayment schedule. Ensure execution and dating by both parties.
- Interest Rate Compliance: Charge interest at or above the AFR published by the IRS for the loan term.
- Evidence of Repayment: Maintain regular payments of interest and/or principal. Keep payment receipts or bank records to demonstrate consistent performance.
- Tax Reporting: The lender must report interest income annually on their tax return. The borrower may deduct interest if eligible.
- Loan Security: Include collateral or guarantees to enhance enforceability, especially for larger loans.
- Financial Capacity: Ensure the borrower has the means to repay—consider including financial disclosures.
- Recordkeeping: Maintain records reflecting the loan on both parties’ balance sheets.
- No Forgiveness Without Planning: Any forgiveness of principal or interest is treated as a gift, unless shielded by exclusions.
- Trustee Prudence (for Trust Loans): Ensure the interest rate reflects market rates, not just AFR, to avoid breaching fiduciary duty.
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