Ever since the Tax Court’s decision in Estate of Graegin v. Commissioner, estates lacking liquidity have used Graegin loans to pay the estate tax, generation-skipping transfer tax, and other administrative estate expenses. Generally, estates are permitted to take an administrative expense deduction, for estate tax purposes, for the future interest payments that are expected to be made on a Graegin loan that is actually and necessarily incurred to address the estate’s expenses. However, taxpayers are not always successful in obtaining the deduction because the extent to which an estate “actually and necessarily” incurs a loan varies greatly on a case-by-case basis.
In Estate of Koons v. Commissioner, the Eleventh Circuit affirmed the Tax Court’s decision to deny an estate the administrative expense deduction for future interest payments on a loan used to satisfy the estate’s tax liability, holding that the loan was not actually and necessarily incurred. In reaching that conclusion, the court looked to the Graegin case.
Graegin involved an estate that consisted primarily of nonprobate assets, including a revocable trust for decedent's wife that held stock in a family-owned company. The Graegin estate lacked liquidity, as the approximate net value of the estate's liquid assets totaled $20,000 against an estimated estate tax liability of $204,000. To avoid a forced sale of the stock in the family company, the estate borrowed the amount of the estate tax due from a wholly owned subsidiary of the family company in exchange for an unsecured promissory note bearing interest at the then-prime rate. Under the terms of the promissory note, principal and interest were due in a single balloon payment 15 years after the note was executed and prepayment was prohibited. The 15 year term was based on the life expectancy of the decedent’s wife, because assets in her trust would be available to partially satisfy the note. On its federal estate tax return, the estate deducted approximately $460,000, the amount of the single interest payment due upon maturity of the note after the 15-year term. The court allowed the deduction of the interest as a reasonable and necessary administration expense for the entire 15-year period.
In Koons, the decedent’s estate also consisted primarily of nonprobate assets, the majority of which consisted of stock in a closely held limited liability company (LLC). However, unlike in Graegin, the approximate net value of the Koons estate was more than $200 million in liquid assets (the bulk of which was held in a trust) against an estimated estate tax liability of $43 million. The remaining liquid assets of the estate outside of the trust were insufficient to pay the estate tax due. To avoid a forced sale of the LLC’s stock and to protect the LLC’s plans to invest in operating businesses (plans the decedent wanted to continue after his death), the estate borrowed $10.75 million from the LLC in exchange for a promissory note bearing an annual interest rate of 9.5%. Under the terms of the promissory note, no payment was due for 18 years, principal and interest were due in 14 equal semi-annual installments starting in the year 2024, and prepayment was prohibited. On its federal estate tax return, the estate deducted approximately $71 million for the future interest payments as an administrative expense deduction. Because the trust’s primary asset was its interest in the LLC, the estate anticipated that the loan would be repaid with distributions from the LLC.
The court distinguished Graegin from Koons and concluded that the $71 million interest deduction in Koons was properly denied by the Tax Court. In Graegin, the estate lacked liquidity and as a result obtained a loan to avoid selling its assets at a loss to pay its debts, thus, the related interest payments were necessarily incurred. In Koons, not only did the estate have plenty of liquid assets, but it obtained a loan that would eventually have to be repaid using the very same liquid assets that could have been used to directly pay the tax liability in the first place. Thus, the interest payments were not necessarily incurred. The court determined that regardless of whether the Koons estate obtained a loan and repaid it or immediately ordered a distribution, the LLC stock would have to be sold. The only difference between the two approaches, the court noted, is that the former resulted in a tax deduction.
Overall, in the court’s eyes this arrangement with the loan was not actually and necessarily incurred, as it did more to hinder the proper settlement of the Koons estate than it did to assist with its administration. Aside from the decedent’s desire for the company to continue investments, the Koons estate hardly provided a good reason for keeping the estate open for as long as would be necessary (around 25 years) to start, continue and finish the loan repayments. Perhaps the outcome would have been different if the Koons estate had structured the loan using a more reasonable repayment schedule, or had more adequately explained why the $200 million in assets was so vital to the company’s future (beyond investments in operating businesses) that it could not be distributed. Maybe then the court would have viewed the loan as a more feasible option.
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