Tax Court Confirms AFR-Compliant Loans to a Related Party Are Not Gifts

By: William L. Bricker, Linda Galler, and Matthew Crawford

For years, tax advisors have debated whether Section 7872 of the Internal Revenue Code is a safe haven for related party loans. The issue is how Section 7872 relates to the five factors in Section 385 and the long line of cases that address the question of whether an advance of funds should be treated as a loan for federal tax purposes. Those who are of the view that Section 7872 is a safe harbor took solace over the years in the general stance of the Tax Court, which favored the “safe harbor” interpretation. See, e.g., Frazee v. C.I.R., 98 T.C. 554 (1992).

The Tax Court recently reaffirmed that related-party loans bearing interest at the Applicable Federal Rate (AFR) of Section 7872 can be respected. In Estate of Galli v. Commissioner, Docket No. 7003-20 (2025), the decedent had loaned $2.3 million to her son through an unsecured, 9-year note bearing 1.01% interest—the mid-term AFR at the time (and well below the prevailing market rate). Her son made timely interest payments, which the decedent reported as income on her tax returns. Upon the decedent’s death 3 years later, her estate included the remaining loan balance as part of her total assets, discounted to reflect the risk that it might not be fully repaid.

The IRS argued that the loan was a gift, which the decedent had failed to report for gift tax purposes.  It noted the absence of collateral, the borrower’s possible inability to repay the loan, and the below-market interest rate.  In reaching its decision to respect the loan, the Tax Court relied on three factors: a note bearing interest at the AFR at that time signed by both the lender and borrower, a fixed term, and the fact that interest payments had been made.  Because the loan at issue satisfied the Section 7872 interest rate (AFR), was evidenced by a note, and actual payments were made, the Tax Court regarded it as a loan rather than a gift.

Galli underscores the importance of properly structuring loans to related parties, which often face heightened scrutiny. To withstand challenge, lenders should use written promissory notes, charge interest at the appropriate AFR (or more), and report payments properly.  Borrowers should comply with terms of the loan by making payments when they are required.