Proof That Dotting the I's and Crossing the T's Keeps the IRS at Bay

I have given several presentations over the last few weeks to various professional groups about IRS procedures and representing clients in IRS controversies, including IRS examinations, appeals and litigation. In every presentation I discuss how it is very important to be diligent in every transaction, large or small, and that every detail is covered, i.e., dot the I’s and cross the T’s. The IRS is always looking to attack transactions where a taxpayer failed to follow proper procedures or took short cuts. A taxpayer does not want to be “low hanging fruit” for the IRS to pick.

In a March 5, 2025 order granting the taxpayers’ motions for partial summary judgment in Estate of Barbara Galli, et. al. v. Commissioner, No. 7003-20 and 7005-20, the U.S. Tax Court confirmed that dotting the I’s and crossing the T’s can result in a taxpayer win. In Galli, Barbara Galli made a $2.3 million loan to her only child, Stephen, in February 2013. The parties to the loan executed a simple unsecured note that provided for a 9-year term and an interest rate of 1.01%. The note required annual payments of interest, with repayment of the principal due at the end of the term. Although the interest rate of 1.01% might appear to be low, that was the applicable Federal rate at the time of the loan.

Barbara Galli died in 2016 and during the IRS examination of the estate’s Form 706, Estate Tax Return, the IRS determined that a Form 709, Gift Tax Return, should have been filed for the 2013 loan transaction because it was in whole or in part a gift. The IRS challenged the transaction on various grounds including that it had not been shown that the decedent had the intent to create a legally enforceable loan or that she expected repayment. Alternatively, the IRS argued that due to the 1.01% interest rate it was a below-market loan and partially a gift. The IRS issued Notices of Deficiency for both the Form 706 and Form 709 and the estate filed petitions in the Tax Court challenging the IRS determinations.

The estate filed motions for summary judgment in both cases regarding the loan. In support of the motions, the estate provided a copy of the decedent’s bank records showing a transfer of $2.3 million, the fully executed promissory note, the son’s bank records that showed he paid interest to his mother each year and the decedent’s income tax returns that showed she reported the interest as income each year. In other words, the estate showed that the parties to the loan dotted all the I’s and crossed all the T’s. In response, the IRS introduced evidence that the decedent did not file a gift tax return to report the transaction with her son, a fact upon which everyone agreed. The court determined that the transaction was a loan between the decedent and her son citing the fully executed note, interest payments, etc. Regarding the 1.01% interest rate, the court turned to IRC Section 7872 which governs the field of loans with below-market interest rates. Section 7872 defines a “below-market loan” as a loan with an interest rate less than the applicable Federal rate. The court found that the loan was not a loan with a below-market interest rate because at the time of the loan, February 2013, the applicable federal rate was 1.01%.

A very good win for the taxpayer but it is not clear from the Court’s order why the IRS ever challenged the transaction. The IRS typically challenges transactions with definite issues, but in Galli the taxpayer did everything correctly, with a note, payments, and a proper interest rate.

So, lesson one for any taxpayer is to dot the I’s and cross the T’s to avoid IRS problems. There is also a second lesson from Galli. Barbara Galli did not file a gift tax return because she correctly believed she did not make a gift. However, because she did not file a gift tax return, the statute of limitations for the IRS to examine the loan transaction, three years from the date a gift tax return is filed, did not start. That allowed the IRS to review and challenge the transaction years later when it was examining the estate tax return. During the examination of an estate tax return, the IRS will typically ask for all bank records to see if there are any unreported gifts. I assume it did so during the Galli examination and found the $2.3 million transfer to the son. What should Ms. Galli have done? File a gift tax return disclosing the loan transaction and claiming there was not a gift. That would have started the three-year clock for the IRS to challenge the loan transaction.

If you have any questions about this article or any civil or criminal tax matter, please contact me at (214) 749-2456.