Guaranteed Wealth? A New Way of Thinking About the Gift Tax Treatment of Loan Guarantees

Abstract

Wealthy parents have found an ingenious way to magnify their children’s assets without paying gift tax. Rather than transfer assets to the children directly, a parent may encourage her children (or trusts for the children’s benefit) to borrow funds as needed to make investments. The parent stands behind that debt by making a personal guarantee, assuring the lender of repayment and thereby allowing the children to borrow and invest far more than they otherwise could. The Internal Revenue Service clearly believes that such guarantees should be treated as gifts but has hesitated to press that position or develop a framework for doing so. This Article provides that framework, drawing on analogous corporate tax cases to show the way.

For gift tax purposes, when a person guarantees a loan to a related party, the loan would be recharacterized as a loan from the lender to the guarantor, followed by a second loan on the same terms from the guarantor to the ultimate borrower. Each loan would then be tested under existing doctrines to see whether it should be respected as debt. In most cases, the second deemed loan (from the guarantor to the ultimate borrower) would not be respected as debt, because the ultimate borrower lacks the income or resources to justify the extension of credit. As a result, the second deemed loan would be recharacterized as a gift to the ultimate borrower rather than a loan. This framework would severely curtail the use of guarantees to grow dynastic wealth.