## Facts

- A grandparent (G) had made annual cash gifts of $3,000 to each of two grandchildren (A and B) for years.
- G wanted to transfer two unimproved, non-income-producing parcels to A (FMV $27,000) and B (FMV $24,000).
- A and B had no funds and no independent source of income.
- To reduce gift tax, G’s attorney arranged a purported “sale” of each parcel to the grandchild in exchange for noninterest-bearing, nonnegotiable installment notes scheduled in annual amounts matching the gift tax annual exclusion.
- In July 1972, each grandchild received a package containing a deed, a purchase-money mortgage, notes (one for $2,950 and the rest for $3,000 each), and a $50 check from G; each grandchild simultaneously paid G $50.
- A contemporaneous letter explained that G did not intend to collect the notes and intended to forgive each payment as it became due.
- There were no negotiations; A and B had no prior knowledge of the transaction; G’s attorney represented all parties.
- G forgave the $2,950 installment in December 1972 (before it came due) and forgave $3,000 installments in December 1973 and December 1974.

## Issues

1. Whether the transfer of the two parcels in exchange for the described notes and mortgages was a bona fide, arm’s-length sale for full and adequate consideration.
2. If not a bona fide sale, whether the transaction constituted a transfer subject to federal gift tax under I.R.C. §§ 2501 and 2511 when the property was conveyed.

## Decision

- The IRS concluded the transaction was not a bona fide sale made at arm’s length.
- The IRS treated the conveyances as transfers of real property subject to federal gift tax, rather than as sales followed by separate annual gifts through later note forgiveness.

## Legal Principles

- For gift tax purposes under I.R.C. § 2511, substance controls over form; a transfer labeled a “sale” may be recharacterized as a gift if consideration lacks economic reality.
- A bona fide sale requires genuine arm’s-length dealing and real expectation of repayment; prearranged forgiveness of the “purchase price” indicates the absence of a true debtor-creditor relationship.
- Notes that are noninterest-bearing and nonnegotiable, combined with donees’ inability to pay and a stated intent not to enforce collection, support treating the purported sale consideration as illusory.
- Structuring installment obligations to match the annual exclusion does not prevent gift tax treatment when the overall arrangement is a preplanned device to transfer property without meaningful consideration.

## Conclusion

The IRS ruled that conveying real property to family members in exchange for installment notes designed to be forgiven annually, where repayment is not expected and enforcement is not intended, is a taxable gift of the property at the time of transfer rather than an arm’s-length sale followed by separate annual-exclusion gifts.


Rev. Rul. 77-299, 1977-2 C.B. 343 (1977)