Estates, Trusts & Gifts
The Tax Court held that an estate could deduct as an administration expense interest incurred when a trust that was part of the estate borrowed funds to enable the estate to pay its federal estate tax.
Walter Duncan’s will divided his oil and gas business among his sons Vincent, Raymond, and Walter Jr., with each brother receiving his share of the business in trust. The trust created for Vincent’s benefit (the Walter Trust) named Vincent, his spouse, and his descendants as beneficiaries during his lifetime. The trust granted Vincent the power to appoint the trust’s remainder beneficiaries at his death. Vincent’s son, Vincent Jr., and the Northern Trust Co. (NTC), which is a wholly owned subsidiary of the Northern Trust Corp., have served as the co-trustees of the Walter Trust since September 2005. Vincent also created a revocable trust, the Vincent J. Duncan 2001 Trust (the 2001 Trust), to hold other assets including his own oil and gas business and a ski resort. The amended trust instrument appointed Vincent Jr. and NTC as co-trustees and is governed by Illinois law.
Vincent died in January 2006. His estate, which included the 2001 Trust, sold its marketable securities for approximately $2 million and received a $3.2 million distribution from one of Vincent’s companies. NTC, however, estimated that the estate’s federal estate tax liability would be approximately $11.1 million and determined that the 2001 Trust also needed to retain a cash reserve to satisfy the estate’s other obligations (e.g., ongoing administration expenses and amounts Vincent owed to his former spouse under a divorce decree).
To raise the necessary funds, Vincent Jr. and NTC decided to borrow money. They determined the 2001 Trust needed a 15-year term on the loan because the volatility of oil and gas prices made income from the oil and gas businesses difficult to predict. They accordingly asked the Northern Trust Corp.’s banking department what the market rate was for a 15-year bullet loan. The banking department quoted a rate of 6.7%.
In October 2006, Vincent Jr. and NTC (as co-trustees of both the 2001 Trust and the Walter Trust) executed a secured promissory note (the note) reflecting a loan of almost $6.5 million from the Walter Trust to the 2001 Trust. The loan called for interest at a rate of 6.7%, compounded annually, with all interest and principal payable on October 1, 2021 (i.e., in 15 years). The note expressly prohibited the prepayment of interest and principal.
On a timely filed estate tax return, the value of the assets of the 2001 Trust was included in the value of Vincent’s gross estate. The estate claimed a $10,653,826 deduction for the interest owed to the Walter Trust (interest expense) and a $750,000 deduction for estate settlement services paid to Vincent Jr. and NTC as co-trustees of the 2001 Trust. The estate reported a federal estate tax liability of $8,283,410, which was $2,792,105 less than the amount the estate paid with its extension request. The IRS refunded the difference to the estate. The IRS subsequently issued the estate a deficiency notice with the determination that the interest expense paid to the 2001 Trust was not deductible. The estate challenged this determination in Tax Court.
The Tax Court’s Decision
The Tax Court held that Vincent’s estate could deduct the interest on the loan from the Walter Trust to the 2001 Trust as an administration expense under Sec. 2053. In making its determination, the Tax Court considered three points: (1) whether the loan was a bona fide debt, (2) whether the loan was actually and reasonably necessary to the administration of the estate, and (3) whether the interest expense amount was ascertainable with reasonable certainty.
Bona fide debt: The IRS argued that the loan was not a bona fide debt because the trusts were identical, having the same trustees and beneficiaries. Therefore the loan had no economic consequence. The Tax Court rejected this argument because it ignored both the state and federal law that applied to the trusts. Under Illinois law, a trustee of two distinct trusts is required to maintain the trusts’ individuality. This meant that by law Vincent Jr. and NTC could not ignore the 2001 Trust loan because nonpayment of the loan would improperly impose a loss on the Walter Trust and thereby effectively shift assets to the 2001 Trust. In addition, the Tax Court found that there was no basis in federal tax law for treating the trusts as one trust.
Actually and reasonably necessary: The IRS based its argument that the loan was not actually and reasonably necessary on two factors: (1) The 2001 Trust could have instead sold illiquid assets to the Walter Trust, and (2) the terms of the loan were unreasonable. On the first point, the estate claimed it needed to borrow money because it could not have otherwise met its obligations without selling illiquid assets at reduced prices. The IRS countered that the 2001 Trust did not need to borrow money because it could have sold assets to the Walter Trust at full fair market value. The IRS argued that its position was supported by Estate of Black , 133 T.C. 340 (2009), but the Tax Court found that the IRS had misinterpreted its holding in that case.
Furthermore, the Tax Court found that the 2001 Trust could not have sold assets to the Walter Trust at fair market value. According to the court, if other prospective purchasers had insisted on a discount, Vincent Jr. and NTC (as trustees of the Walter Trust) would have been required to do the same. Under Illinois state law, Vincent Jr. and NTC could not have directed the Walter Trust to purchase the 2001 Trust’s illiquid assets at an unreduced price because they would have improperly shifted the value of the discount from the Walter Trust to the 2001 Trust.
On the issue of whether the terms of the loan were reasonable, the court found that the 15-year length of the loan was reasonable because the volatility in the price of oil and gas made the future income of the estate (and, thus, the necessary length of the loan period) impossible to predict at the time the loan was made. Therefore, it declared it would not use hindsight to determine that the trustees’ decision to use a 15-year period was unreasonable. Because the trustees used the market-based interest rate for the loan, the court also found no reason to second-guess the trustee’s decision on the interest rate. The Tax Court specifically rejected the IRS’s suggestion that the applicable federal long-term rate should have been used, finding it inappropriate because it represents the government’s cost of borrowing, which is inherently lower than a private entity’s cost of borrowing.
Finally, the Tax Court addressed whether the interest could be calculated with reasonable certainty. The IRS claimed that despite a prepayment prohibition in the loan note, because the trustees and beneficiaries of the two trusts were the same, there was no incentive for the Walter Trust to enforce the prepayment prohibition clause. The Tax Court disagreed, finding that prepayment would definitely not occur. As the court had previously discussed, under Illinois law, the Walter Trust and the 2001 Trust are distinct trusts that the trustees must administer separately. Whether interest rates rose or fell, one of the two trusts would be disadvantaged by a prepayment of the loan, so the trustees could not agree to prepay the loan.
This case provides further evidence that there are no blanket rules when it comes to Graegin loans. The estate in this case did enough to convince the court that the loan was bona fide and necessary, but a different judge might have held against the estate on any number of issues, such as whether an interest rate well above the applicable federal rate was reasonable. As recent cases demonstrate (see, e.g., Estate of Gilman , T.C. Memo. 2004-286; Estate of Stick , T.C. Memo. 2010-192; Keller , No. V-02-62 (S.D. Tex. 9/15/10)), the court’s decision often comes down to the particular facts and circumstances.
Estate of Duncan, T.C. Memo. 2011-255