Rev. Rul. 87-69

1987-2 C.B. 46, 1987-31 I.R.B. 6.

INTEREST; DEDUCTION; LOAN FROM CHILD TO PARENT AFTER GIFT OF MONEY TO

CHILD

Published: August 3, 1987

Section 163.-Interest, 26 CFR 1.163-1: Interest deduction in general

  Interest; deduction; loan from child to parent after gift of money to child. No genuine indebtedness exists to support an interest deduction under section 163(a) of the Code where a parent purports to make a cash gift to a child and the child agrees to loan the case back to the parent.

ISSUE

  If a parent purports to make a gift of money to a child under circumstances in which the child agrees to lend the money back to the parent, are payments made pursuant to the purported loan agreement between the parent and child deductible as interest under section 163(a) of the Internal Revenue Code?

FACTS

  A is the parent of B. On May 1, 1987, A gave $40,000 to B. B was given the money with the understanding that B would lend the money to A in exchange for A's note. On May 30, 1987, A borrowed the $40,000 from B. The loan agreement provided for a market rate of interest, was fully secured, and required payment of accrued interest at quarterly intervals. The entire principal balance was due in 4 years. The amounts characterized as 'interest' by the loan agreement were not 'personal interest' within the meaning of section 163(h) of the Code.

LAW AND ANALYSIS

  Section 163(a) of the Code states that, subject to certain limitations, a deduction shall be allowed for all interest paid or accrued within the tax year on indebtedness. The term 'interest' has been defined as compensation for the use or forebearance of money. Deputy v. duPont, 308 U.S. 488 (1940), 1940-1 C.B. 118. For interest to be deductible, the payments must arise from genuine indebtedness, that is, indebtedness in substance and not merely in form. Knetsch v. United States, 364 U.S. 361 (1960), 1961-1 C.B. 34.

  In Guaranty Trust Co. v. Commissioner, 98 F.2d 62 (2d Cir. 1938), the court considered a case in which a husband transferred funds to his wife under a prearranged agreement that had the wife create a trust, with herself as trustee, that returned the money to the husband through a purported loan. The court concluded that the husband did not intend to divest himself of complete dominion and control over the funds because the prearranged agreement restricted the use of the funds to one purpose, namely, to establish a trust that would loan the money back to the husband. Under these circumstances the transfer of funds to the wife was found to be an incomplete gift. The court viewed the husband's note as no more than an unenforceable, gratuitous promise to make a gift, based on neither money nor money's worth. Thus, the loan was not recognized as valid indebtedness. Accord, Elbert v. Commissioner, 45 B.T.A. 685 (1941).

  In this instance, just as in the authorities cited above, the parties have failed to create a genuine debtor-creditor relationship. The transfer of money from A to B is not a completed gift because B received the $40,000 with the understanding that B would return that sum to A. B was merely a conduit for a circular flow of money from A to A. This transaction is not a loan in substance. As in the Guaranty Trust case, A's note is merely a gratuitous promise to make a series of gifts. Accordingly, no interest deduction is allowable for the quarterly payments to B on a purported loan from B to A.

HOLDING

  The parent's payments to the child under the purported loan agreement do not constitute interest paid on indebtedness for purposes of section 163(a) of the Code because no genuine indebtedness exists.

Rev. Rul. 87-69, 1987-2 C.B. 46, 1987-31 I.R.B. 6