The Estate Tax Dilemma: Protecting the Interest Expense Deduction on Estate Loans

Editor: Neal A. Weber, CPA

Estates, Trusts & Gifts

Should taxpayers borrow money to pay estate taxes? In some cases the answer is “yes,” because they will be able to claim a tax deduction for interest and loan costs. Minimizing estate taxes is simply not enough. Taxpayers must also consider how their families will eventually pay the estate tax liability.

Consider a common situation: An estate has as its primary asset a family farm or a closely held business that is an ongoing concern. The decedent’s heirs wish to continue the business. In this case, the estate may not have enough cash or other liquid assets on hand to pay the estate tax on the farm or business. Assuming the estate does not wish to liquidate the business to pay the estate tax, the estate has two options: a Sec. 6166 election or a Graegin loan.

Sec. 6166 Election

A Sec. 6166 election allows the deferral of the first payment for five years and nine months from the decedent’s date of death. Thereafter, each successive payment will be made annually for the next 10 years until the debt has been paid off. However, this election is essentially a loan from the IRS. Depending upon the estate’s financial circumstance, either an IRS lien on the business assets or the procurement of a surety bond by the executor may be required to make this election. A Sec. 6166 election also has other disadvantages.

• This election is restricted to qualified business interests. That is, the decedent must have been the owner of an active business and the decedent’s interest in that business must be at least 35% of his or her adjusted gross estate.
• The election can be lost if the estate is delinquent in making its installment payments or the business is sold during the installment term.

Graegin Loans

The Tax Court introduced and approved the concept of borrowing money to pay estate tax in 1988 in Estate of Graegin, T.C. Memo. 1988-477. The courts continue to accept this strategy, and it remains a cost-effective way of reducing the estate tax and providing estate liquidity for the heirs of the decedent.

A Graegin loan provides an opportunity to use an outside lender instead of the IRS to fund the estate tax loan. The lender can be an external bank or a related party (family limited partnership or irrevocable gift trust) as long as the loan is bona fide. A Graegin loan has the following requirements:

• The estate must be illiquid;
• The loan must be at a fixed rate; and
• The loan must prohibit prepayment.

Most important, a Graegin loan does not have the active business ownership requirements related to a Sec. 6166 election.

Unlike the interest expense for a Sec. 6166 election, a Graegin loan allows the estate to take a full, nondiscounted deduction on the entire interest expense related to the loan as an administrative expense deduction under Sec. 2053. Sec. 2053 deductions include funeral expenses, administrative expenses, and claims against the estate for which the interest expense would qualify. The estate tax deduction includes all interest owed, not only for the current tax year but for all successive years of the loan. Because the amount of the interest to be paid is ascertainable from the beginning, the full amount of the interest to be paid is permitted as a deduction rather than the discounted present value. This can create a sizable estate tax deduction, thereby dramatically reducing the underlying estate tax liability.

Example: J dies with a $10 million taxable estate in 2011. The top federal estate tax rate is 35%. J’s estate therefore owes $3.5 million in federal estate taxes (assume no state estate tax). J’s estate is illiquid (assets cannot be immediately liquidated), so the executor borrows the money to come up with cash to pay the estate taxes. The executor borrows $2.7 million at 5.5% for 15 years. The note requires a balloon payment of principal and interest at the end of the 15-year period. The accumulated interest payment at the end of 15 years will be $2.2 million.

The full amount of the interest is deductible on J’s federal estate tax return due nine months after the date of death, even though the interest is not actually payable for 15 years. When the interest is deducted, the taxable estate is reduced to $7.7 million, which results in a federal estate tax of $2.7 million. The federal estate tax is reduced from $3.5 million to $2.7 million, a savings of $800,000.

Graegin Loans and Sec. 2053 Requirements

For the interest to be deductible, the claimed interest must satisfy the requirements of Sec. 2053. Under Sec. 2053, such expenses must also be allowable by the law of the jurisdiction under which the estate is being administered. Currently 14 states and the District of Columbia have decoupled from the federal estate tax, providing an additional state tax deduction.

In addition, Regs. Sec. 20.2053-3(a) provides that the amounts deductible as “administration expenses” from a decedent’s gross estate are limited to such expenses as are actually and necessarily incurred in the administration of the decedent’s estate—that is, in the collection of assets, payment of debts, and distribution of property to the persons entitled to it. Administrative expenses include executor’s commissions, attorneys’ fees, and miscellaneous expenses such as court costs, accountants’ fees, appraisers’ fees, etc. Expenses are limited to the settlement of an estate and the transfer of the estate property to individual beneficiaries or to a trustee. Expenditures not essential to the proper settlement of the estate but incurred for the individual benefit of the heirs, legatees, or devisees may not be taken as deductions. For example, expenses for preserving and caring for estate property may not include outlays for additions or improvements to the property. Therefore, in order to claim the interest expense as an administrative deduction, the estate must show that the expense was actually and necessarily incurred in the administration of the decedent’s estate.

Graegin Loans and Recent Court Decisions

In cases involving Graegin loans, the courts have held both in favor of the
taxpayer and against the taxpayer, depending on the circumstances of each case. For example, in Estate of Gilman, T.C. Memo. 2004-286, the Tax Court permitted the estate a deduction for the interest and closing costs associated with the portion of the loan obtained to enable the estate to pay the estate taxes. The interest and closing costs associated with the portion of the loan used to pay for nondeductible estate expenses, such as compensation of an executive of a business connected to the decedent, were not deductible. Gilman’s will provided for cash bequests of approximately $30 million, and the residue of his estate was to be distributed to his foundation.

The executors of his will received tax advice that by restructuring all the estate assets, the estate would save $160 million in capital gain taxes. The executors implemented the restructuring plan. After the restructuring, the estate consisted of $40 million in cash and real estate and $143 million in promissory notes. The Tax Court found that after paying the taxpayer’s cash bequests, the estate’s remaining assets were illiquid, and therefore the loan was necessary. The Gilman case demonstrates that specific bequests to beneficiaries can affect an estate’s liquidity needs, providing an opportunity to qualify for a fixed rate loan to pay the estate taxes.

In Estate of Stick, T.C. Memo. 2010-192, the Tax Court held that the interest on a loan used to pay the estate tax liability was not permitted as a deduction because the estate was unable to show that the loan was necessary. The estate appeared to have sufficient liquid assets to pay the tax obligations without borrowing funds.

In a much more complex case, Keller, No. V-02-62 (S.D. Tex. 9/14/10), a district court found in favor of the taxpayer. The court allowed an administrative expense deduction for all the interest paid on a loan because the court was satisfied the loan was necessary to preserve the estate’s liquidity and to pay the estate taxes, and the estate planned to repay the loan.

Summary

The courts tend to take a hard look to see if a loan is really necessary for payment of estate taxes, so careful planning is essential. The loan must be bona fide and at a fixed rate, the amount of interest paid should be ascertainable from the beginning in order for the full amount to be permitted as a deduction, the estate must be illiquid, and the taxpayer must be able to show that the loan is actually necessary in order to pay the estate tax. If these requirements can be met, Graegin loans can be an indispensible option for estates seeking liquidity to pay expenses without liquidating the underlying estate assets.

EditorNotes

Neal Weber is managing director-in-charge, Washington National Tax, with RSM McGladrey, Inc., in Washington, DC.

For additional information about these items, contact Mr. Weber at (202) 370-8213 or neal.weber@mcgladrey.com.

Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.