IRS reverses prior position on estate tax ramifications of loan guarantees; remains silent as to gift tax implications.

In December 1990, the IRS issued Letter Ruling 9113009, detailing the gift and estate tax consequences of a taxpayer who gratuitously guaranteed a loan. In this ruling, a taxpayer who had guaranteed loans made to corporations owned by his children was deemed to have made a taxable gift at the time the guarantee was made. No mention was made as to how that gift should be valued; however, the IRS also indicated that if the parent actually had to make good on any part of his guarantee, an additional gift would be imputed at the time of payment.

The ruling also indicated that, from an estate tax perspective, the marital deduction would be disallowed. Under the terms of the guarantee, the Service reasoned, the taxpayer's estate would become liable for the loan guarantee; any property that could be used to satisfy that guarantee could not qualify for the marital deduction, since such property was at least potentially "encumbered" with the guarantee. Since many parents guarantee their children's loans, this ruling has caused great concern.

In Letter Ruling 9409018, the IRS reversed its 1990 ruling and stated that the marital deduction should not be reduced by the entire unpaid balance of the guaranteed loans, unless at the time of the taxpayer's death it appeared that a default was imminent, performance under the guarantee was likely and any subrogation rights were worthless.

If it was determined that the marital deduction would have to be reduced as a result of default being imminent, the estate should be able to take a deduction for payment of the guaranteed obligation. In Letter Ruling (TAM) 9321004, the question arose as to whether a decedent's estate could claim a deduction under Sec. 2053(a)(3) for a postdeath payment resulting from a guarantee arrangement entered into by the decedent. At the time of death, a default had not yet occurred. The Service ruled that the estate was entitled to a deduction, because the estate's postdeath payment was pursuant to a personal obligation of the decedent existing at the time of his death. Thus, guarantees should no longer pose an estate tax problem.

While taxpayers may applaud the revocation of Letter Ruling 9113009, the IRS specifically stated that it expressed no opinion about the gift tax consequences detailed in the original ruling. Since letter rulings may not be relied on as substantial authority, the fact that no comment was made on the gift tax issues may indicate that the Service has not yet reached a conclusion on this question and the taxpayer is not yet out of the woods.

It is still unknown how broad a view the IRS will take in defining a gift. The Service may still maintain that guarantees of pavement are economic benefits that should be valued when an agreement is executed. Clearly, it could be argued that if guarantees were not given, the loans might not be made or would certainly be made at less favorable rates. The difficulty in placing a value on the guarantee, however, may cause the transaction to be treated as "open" for gift tax purposes; as such, the only gift to be reported is at the time the parent must fulfill his guarantee obligation, thereby actually closing the transaction.

In Letter Ruling 9113009, the taxpayer argued unsuccessfully that at the time the guarantee was issued, the taxpayer merely promised to pay if in the future a default occurred. Since there was no current diminution of the estate, no present transfer took place. Relying on Dickman, 465 US 330 (1984), the IRS rejected the taxpayer's position and stated that the term "gift" was meant to be used in "its broadest and most comprehensive sense." Letter Ruling 9409018 did not address this issue.

If the Service were successful in asserting that a gift was made at the time the guarantee was obtained, one approach to valuing the guarantee would be to review the cost of obtaining a commercial suretyship promise for the same obligation. In many cases, the value of this guarantee would be less than the annual exclusion. An important question then becomes whether the guarantee would qualify as a gift of a present interest. This too is unanswered by the 1994 ruling; however, it would appear that if the argument were made that a gift has occurred in that a valuable asset has been transferred, it would seem that this should qualify as a gift of a present interest.

Until more guidance is offered, taxpayers should be cautious when dealing with guarantees. It may also be prudent for the taxpayer to value the guarantee at the time the agreements are executed and use the annual exclusion, as the taxpayer's valuation will probably be more favorable than that asserted by the IRS.

From Carrine K. Reilly, J.D., Walpert, Smullian & Blumenthal, P.A., Baltimore, Md.