Taxing Lessons Case Summaries

Case — Deductibility of Interest

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TL Case Summ

THE QUESTION

Can an estate deduct interest on funds borrowed to enable payment of federal estate tax?

THE DISPUTE

Taxpayer Says: The loan was necessary to avoid a forced sale of illiquid estate assets, and the interest is deductible.

Internal Revenue Service Says: The interest expense is not deductible because the loan was not a bona fide debt nor necessary for estate administration, and the amount of the expense is not ascertainable with reasonable certainty.

THE LAW

From Internal Revenue Code Section 2053(a)(2): The value of a decedent’s taxable estate is determined by deducting from the value of the gross estate certain amounts including administration expenses allowable by the laws of the jurisdiction where the estate is administered.

From Internal Revenue Code Section 2053(c)(1)(A): An estate administration expense deduction for any indebtedness is limited to the extent that the indebtedness was contracted bona fide and for adequate and full consideration in money or money’s worth.

From Federal Tax Regulation 20.2053-1(b)(3): An item may be deducted even if its exact amount is not then known as long as it is ascertainable with reasonable certainty and will be paid. A deduction may not be claimed based upon a vague or uncertain estimate.

From Federal Tax Regulation 20.2053-3(a): The amount of deductible administration expenses is limited to those expenses which are actually and necessarily incurred in the administration of the estate.

From Litton Bus. Sys., Inc. v. Commissioner, 61 T.C. 367, 377 (1973): The ultimate questions are whether there was a genuine intention to create a debt with a reasonable expectation of repayment and whether that intention fits the economic reality of creating a debtor-creditor relationship.

From Estate of Graegin v. Commissioner, T.C. Memo. 1988-477: Expenses incurred to prevent financial loss resulting from a forced sale of an estate’s assets to pay estate taxes are deductible administration expenses.

THE CAUSE OF THE DISPUTE

You can claim a deduction on an estate tax return for expenses incurred to settle the estate and pass the assets to the beneficiaries. These “administrative” expenses must be necessary for the proper settlement of the estate, as well as allowable under local law.

Interest expense on loans taken out to pay estate taxes when the estate would otherwise have to sell illiquid assets is one example of allowable administrative expenses, as long as the loan is genuine and necessary, and the amount of interest is reasonably calculable.

In this case, the estate assets included limited partnership interests in oil and gas businesses, real estate, and a trust. The decedent also held a power of appointment over a second trust. The two trusts shared the same trustees and the same beneficiaries and were governed by Illinois state law, which required that each trust stand alone, with no comingling of assets.

The executor calculated an estate tax of approximately $11 million. Because the estate assets were difficult to sell, the executor determined a loan of $6.4 million was required to make the tax payment. The loan was made from one trust to the other, using a 15-year promissory note with a clause prohibiting prepayment and a 6.7% interest rate.

The executor claimed an administrative deduction of $10.6 million for interest expense payable on the loan.

The IRS says the interest is not deductible because the estate could have sold the assets to the second trust to raise money instead of borrowing. In addition, the loan lacks economic substance because both trusts have the same trustees and beneficiaries, meaning there was no indication the estate intended to create a genuine debt. Finally, the amount of interest expense is not determinable, since the estate could pay the loan back early. While the IRS admits the loan papers prohibit early repayment, neither trust has an economic interest in enforcing the prohibition.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 35KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Right answer!
Sorry, wrong answer :(
For the taxpayer. IRS arguments that the loan is not bona fide fail because they ignore federal tax law and state law regarding the separation of trusts. The IRS conclusion that the first trust could have sold assets to the second trust at fair market value is also incorrect. If other prospective purchasers had insisted on a discount, the trustees of the second trust would have been required to do the same. In addition, prepayment resulting in unascertainable interest expense would not occur because both are distinct trusts to be administered separately and the trustees are required to look out for the best interests of each trust. The loan was a bona fide debt, the interest expense was actually and necessarily incurred in the administration of the estate, and the amount of interest was ascertainable with reasonable certainty. The taxpayer is entitled to deduct the interest as an estate administration expense under section 2053.
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