Family members often transfer businesses to the younger generation via personal loans. Both the person who owns the business and the heir to the business sign a promissory note and the heir must pay back the loan every month. The federal government sets the Applicable Federal Rate, or AFR, every month; as long as the business owner does not charge less than this amount of interest, the Internal Revenue Service doesn't assess gift taxes on the sale. If the AFR drops, the business owner may replace the promissory note to account for lower interest rates without paying gift taxes.
As of August 2011, the Internal Revenue Service does not assess gift taxes if you replace a promissory note with a new one once AFR rates drop. The IRS considers the new note to have the same value as the old note, as they have the same face value. The only thing that has changed is the interest rate, not the value of the loan. Thus, you can replace your promissory note without paying gift taxes.
The Internal Revenue Service considers loans to be below-market if the lender charges annual interest that is less than the AFR rate. These types of loans are subject to different restrictions; thus, lenders have to be careful if the AFR rate increases because then the original note may be considered a below-market loan. However, if the AFR rate decreases or stays steady, the loan is not a below-market loan and thus the lender can replace the promissory note without worrying about gift taxes.
Age of Note
The IRS regulations on promissory notes depend on whether the old note and new note have the same face value. If they do, the IRS doesn't consider the replacement of the note to be a gift. If the promissory note is several years old when the lender replaces it, the old note might not have the same value as the new note due to changes in market conditions over time. However, if the interest rate on the old note is lower than what the borrower could expect to get from a commercial lender, the IRS does not consider the replacement of the note to be a gift.
The IRS laws regarding promissory notes and gift taxes apply only to notes between family members -- i.e., an older family member lends money to a younger family member and signs a promissory note requiring the younger family member to pay the loan back with interest. Loans between non-related persons are considered commercial loans rather than personal loans, and the IRS evaluates these loans based on commercial law. If a lender forgoes interest on this type of note as part of the refinancing process, the forgone interest may be considered a gift and is subject to gift tax.
- Social Science Research Network: Gift Tax Effects of Substituting a Lower AFR Note for a Higher AFR Note; Jonathan G. Blattmachr, Bridget J. Crawford & Elisabeth O. Madden; 2008
- Tax Almanac: Treasury Laws Section 25.2512-2
- U.S. Securities and Exchange Commission. "Promissory Notes." Accessed Aug. 21, 2020.
- Sacramento County Public Law Library. "Real Property as Security for a Loan." Page 1. Accessed Aug. 21, 2020.
Jack Ori has been a writer since 2009. He has worked with clients in the legal, financial and nonprofit industries, as well as contributed self-help articles to various publications.