In this week’s feature article, Professor Eric Reis examines the gift tax consequences of gratuitous loan guarantees. A prototypical example is one in which a parent provides a guarantee for a loan to a child, where the child does not have enough assets or income to qualify for a loan on her own. As the author describes it, wealth is effectively transferred from the parent to the child because the child will benefit from the upside (if the asset appreciates more than the interest on the loan, the child will pocket the difference) but will have little to no exposure to the downside (if the asset depreciates in value, the parent will likely cover the difference). The author goes on to describe a number of similar structures involving children who are shareholders in corporations or beneficiaries of trusts and a parental guarantee of loans to the corporation or the trust.

In Dickman v. Commissioner, the Supreme Court held that the economic value of a gratuitous low-interest loan constitutes a gift from the lender to the borrower and is subject to gift tax. In IRC §7872, Congress codified and expanded that ruling and, importantly, provided formulas for quantifying the value of the gift. The author argues that by its language and logic, Dickman applies not only to the economic value of a low-interest loan, but also to the economic value of a loan guarantee. The author further argues that the point in time at which the gift occurs and is taxable is when the guarantee is given and not, for example, when the guarantor is called upon to pay under the guarantee. However, this raises an extraordinary thorny problem of valuation, and the author describes a number of ultimately unsuccessful attempts to quantify the amount of the gift.

As a means of overcoming these difficulties, the author proposes recasting the guarantee as a pair of loans: from the lender to the guarantor and (on identical terms) from the guarantor to the borrower. The former is an ordinary commercial loan. The latter must be further examined. If the borrower could have obtained the loan on her own, even at much higher rates (“perhaps at an onerous, loan-shark rate from the seediest car lot around”), then there are no gift tax consequences, provided, as is likely to be the case, that the interest on the loan is not less than that prescribed by IRC §7872. However, if the borrower could not have obtained a loan at any interest rate, then the deemed loan from the guarantor to the borrower will be re-recast as a gift in the full amount of the loan.

For support, the author turns to the field of corporate taxation. When a shareholder advances a loan to a corporation, the question arises as to whether for tax purposes we should view the transfer as a loan or as an investment in corporate equity. A number of the tests that are used to make this determination focus upon whether the corporation could have obtained such a loan from a third-party lender. If it could not, there is good chance that the putative loan will be recast as an equity investment.

The article’s argument that a loan guarantee has economic value that should not be ignored for tax purposes is well taken. His point that quantifying such economic value is fraught with difficulty and may in practice be indeterminable is readily apparent. In attempting to overcoming the difficulties, the proposal to recast the guarantee into a dual loan (from the lender to the guarantor and from the guarantor to the borrow) is promising: it is often the case that recasting a conceptually complex arrangement into a series of other, more easily analyzable transactions, is the key to solving the conundrums that arise.

The point with regard to which I was not entirely convinced is the next step of recharacterizing one of the deemed loans (from the guarantor to the borrower) as a gift of the entire principle of the loan. Even if the borrower could not have obtained a loan on her own, her obligation to repay has economic value. One who gratuitously guarantees a loan has seemingly given less than who makes an outright gift of the same amount, yet under the proposal, both would suffer the same gift tax consequences. A related problem is how to characterize payment of interest or of principle from the borrower to the lender (recast as payments from the borrower to the guarantor). If the original transfer was a gift, are these payments gifts from the borrower to the guarantor (for which the borrower would now be liable for gift tax)? That construction does not seem to reflect the underlying relationship between the parties or the substance of the transaction. Are they somehow a repudiation of the original gift? If so, how would this affect the guarantor’s gift tax liability and how would we treat what the contractual arrangements describe as interest? When a loan to a corporation is recast as an investment in corporate equity, then what the contract describes as interest and repayments of principle are recast as distributions (dividends or distributions out of capital, depending upon the corporation’s earnings and profits). The analogy does not seem to help with regard to the deemed payment from the borrower to the guarantor.

Another comment I have is that although the article does not state so explicitly, the necessary implication is that the gift model applies not only to loan guarantees but also to direct loans when the borrower has no creditworthiness and could not have obtained a loan on her own. In other words, the scope of the proposal is must broader than the narrow case of loan guarantees, which is simply one example of its application. It is not clear to me why the author limited the ambit of the proposal and makes no mention of the possibility of recasting direct gratuitous loans as gifts.

Summing up, the article is a very interesting attempt to analyze the tax consequences of gratuitous loan guarantees, a subject which to the best of my knowledge has not been adequately discussed in the literature. I look forward to reading the final version when it is published.