Related Party Loans Can Reduce And Fund Estate Taxes

January 2012

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The expected significant change in the estate tax at the end of 2012 should cause most affluent persons to engage in estate planning. Usually, this will involve an irrevocable trust. One issue that invariably arises is how a future estate tax will be paid for those assets that have not been removed from the estate. A recent tax case provides relaxed guidelines for the use of related party loans, with an administrative cost deduction for the interest.

Generally, courts have found interest to be deductible as an estate administration expense if it meets the requirements of IRC 2053(a)(2) and the related regulations. The leading initial case on this subject is the Estate of Graegin vs. Commissioner, T.C. Memo 1988 – 477. In Graegin, the estate had a liquidity problem that was addressed by borrowing from the decedent’s closely-held business on a 15-year, unsecured, single-payment note. Voluntary repayment or an involuntary acceleration was prohibited. The estate claimed an immediate interest deduction for what would be paid at the end of the fifteen-year period. The IRS disallowed the deduction on the grounds that the debt was not ordinary and necessary, that the loan was not a true loan, and because the interest was not reasonably certain to be paid. In Graegin, the Court allowed the deduction.

In allowing the deduction, the Graegin estate received the following economic benefits over borrowing the amount necessary to pay the federal estate taxes:

The Court allowed a current deduction for the amount that had not yet been paid, and further did not limit the deduction to the discounted present value of the amount that would be paid at the end of the fifteen-year period.
The interest deduction relating to the estate tax was more valuable because the estate tax rate was higher than the income tax rate that would be effective had the interest been treated as an itemized income tax deduction.
Even if a similar loan could be arranged, the interest was paid to a related party, thus keeping the interest payments within the related party group, vs. paying the same amount to an unrelated lender.

The Graegin case requires that (i) the loan and interest cannot be prepaid, and (ii) the loan is necessitated by the estate’s liquidity needs. Based on these requirements, the IRS has been successful in disallowing deductions in other cases where these requirements have not been met.

The recent case, Estate of Duncan v. Commissioner, T.C. Memo 2011-255 explored a fact pattern in which the debtor (a revocable trust) and lender (an irrevocable trust) had the same trustees and beneficiaries, and so were identical in terms of interests and control.

The Tax Court upheld the administration cost deduction because:

Even though the trusts had the same economic interests, the trustees had the responsibility for treating each trust separately. There was nothing that would allow the trustees to merge the trusts, and the trusts needed to be respected under state law. Effectively, the Court did not force the trust with the obligation to fund estate taxes to sell its assets to the related trust that had sufficient liquidity (vs. taking the loan).
The lack of negotiations over the loan rate did not cause the loan to be less real because the rate came from a third-party quote. In the Court’s words, "formal negotiations would have amounted to nothing more than playacting, and to impose such a requirement on the co-trustees would be absurd”. The court specifically rejected the lower long term federal rate which the IRS desired because the riskiness of the loan was greater that the risks involved with U.S. federal government lending.
The Court respected the fifteen-year term of the loan, even though hindsight showed that the loan could be paid earlier. At the time of the loan, market conditions (largely involving the trust’s oil & gas resources) had uncertain cash flow timing and related riskiness, which in turn warranted a long term in which to obtain the resources to repay the loan and interest.

The reaffirmation of the Graegin conclusion using the facts of the Duncan case provides flexibility to estate administration, and should be of great relief to those who are planning their estates.

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