Under Internal Revenue Code Section 2053, the Internal Revenue Service published proposed regulations. (Federal Register:
Guidance Under Section 2053 Regarding Deduction for Interest Expense and Amounts Paid Under a Personal Guarantee, Certain Substantiation Requirements, and Applicability of Present Value Concepts.) They:
(1) provide guidance on the application of present-value principles in determining the amount that an estate may deduct for funeral costs, administration costs, and certain claims made against the estate;
(2) provide guidance on the deductibility of interest expense accruing on taxes and penalties owed by an estate, as well as interest expense accruing on certain loan obligations incurred by an estate; and
(3) amend and clarify the requirements for substantiating the value of a claim against an estate.
The Three-Year Grace Period
To calculate the amount that is deductible under Internal Revenue Code Section 2053, present-value principles should be applied by the proposed regs.
In the preamble to the proposed regulations, it is stated that limiting the amount deductible to the present value of amounts paid after a prolonged post-death period will more accurately reflect the economic realities of the transaction, the true economic cost of that expense or claim, and the amount not going to the estate’s beneficiaries.
Determining the amount deductible for claims and expenses is therefore done using present-value principles in the proposed regs, with a few exceptions (including for unpaid principal of mortgages and certain other indebtedness).
In particular, the “grace period” is the third anniversary of the decedent’s death, and the proposed regulations provide for computing the present value of the amount of any deductible claim or expense that has not been paid or that must be paid on or before that date.
The applicable federal rate, as determined by IRC Section 1274(d) for the month in which the decedent’s date of death occurs, compounded yearly, is to be applied as the discount rate.
According to the proposed regulations, any present value computations must be included in a supporting statement that is submitted along with the Form 706 estate tax return.
They also stipulate that a written appraisal document must typically include the projected date or dates of payment.
Tax and penalty interest are due.
The IRS has found, as stated in the preamble, that interest due on the unpaid estate tax in connection with an extension under IRC Section 6161 or a deferral under IRC Section 6163 is inevitably incurred in the administration of the estate.
Additionally, the proposed regs acknowledge that interest on estate tax instalment payments authorized under Section 6166 is not deductible for estate tax purposes.
This is a point that seemed obvious but presumably lent itself through its repetition in connection with the proposed regs’ coining of the term “non-section 6166 interest” to describe all other situations in which interest can be payable in connection with the administration of an estate.
The proposed regulations hold that non-Section 6166 interest that has accrued on unpaid tax and penalties related to an underpayment of tax or deficiency and that is attributable to an executor’s negligence, disregard of the rules or regulations, or fraud with intent to evade tax isn’t an expense actually and necessarily incurred in the administration of the estate.
In light of this, interest on taxes isn’t deductible to the degree it’s the result of an executor’s carelessness, disrespect for the law or other regulations that apply, or fraud intended to cheat taxes.
Various Loan Obligations May Include Interest
The “Graegin loans” (Estate of Graegin v. Commissioner, T.C. Memo. 1988-477) and alleged attempts by estates to “concoct” illiquidity to be addressed through loan agreements with related parties that forbid prepayment of principal and interest before the loan’s maturity date are targeted by the proposed regulations.
Despite the reasonableness of the IRS’s concern, the proposed regulations’ treatment plan is overly harsh.
The preamble recognizes that some estates have real liquidity problems that necessitate finding a way to pay off their debts and that sometimes the only or best way to get the liquid cash needed is to take out a loan obligation with interest.
However, if liquidity has been purposefully created (either through estate planning or by the estate with knowledge or reason to know of the estate tax liability) before the creation of the loan obligation to pay estate expenses and liabilities, the underlying loan may be legitimate but (according to the preamble) “most likely will not be found to be actually and necessarily incurred in the administration of the estate.” (Preamble, paragraph 15, emphasis added.)
According to the proposed regulations, interest costs are only deductible if, among other requirements, they are genuinely and unavoidably incurred during the administration of the decedent’s estate and are necessary for the proper settlement of the estate.
In addition, the proposed regulations offer a non-exhaustive list of elements to take into account when deciding whether interest paid on a loan obligation of this kind by an estate satisfies the relevant standards.
One of them is whether the executor enters into the loan agreement with a lender who isn’t a significant beneficiary of the decedent’s estate (or an entity controlled by such a beneficiary) at a time when there isn’t an alternative to obtaining the necessary liquid funds to satisfy estate obligations.
The preamble proposes a situation in which the requirement for the loan or any loan conditions is fabricated to produce or raise the amount of a deduction for the interest expenditure; in that scenario, the interest isn’t deductible.
The preamble further states that interest accruing on the loan isn’t necessarily incurred in the administration of the estate (and isn’t therefore deductible) if the loan obligation had an extended loan term with a single balloon payment that didn’t correspond with the estate’s capacity to repay the loan.
The IRS seems to be paying more attention to both estate planning done during the decedent’s lifetime that results in post-death illiquidity as well as activities made after death that may induce illiquidity.
This ignores the fact that there might be important non-tax reasons for taxpayers to structure their holdings in ways that might not be liquid, such as to prevent succeeding generations from selling their inherited business interests that the decedent has spent a lifetime creating from scratch.
An irrevocable life insurance trust (ILIT) is frequently used to provide a liquidity source outside of the decedent’s taxable estate, with the trustee of the ILIT frequently lending the cash earned through insurance proceeds to the executor to assist in funding the payment of estate taxes.
To explicitly exempt such predeath funding arrangements from restricting an estate’s ability to deduct interest, the draft regulations will need to be changed. These arrangements can also be made through business companies.
Value Supporting a Claim Against an Estate
The application of the “qualified appraiser” and “qualified appraisal” requirements in this situation has been given another look by the IRS, according to the preamble.
Instead, a written appraisal that accurately depicts the claim’s current value must be provided by the proposed regulations when the Form 706 estate tax return is being filed.
Both post-death occurrences that have already occurred before the deduction is requested and those that are logically expected to happen should be included when determining the claim’s current value.
Deductibility of Amounts Paid Under a Personal Guarantee
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According to the proposed regulations, a claim that is based on a decedent’s personal guarantee of another person’s debt qualifies as a claim based on a promise and must, therefore, meet all applicable requirements.
More specifically, the guarantee had to be genuine and given in return for fair value, whether that be cash or cash equivalent (as opposed to gratuitous, even if enforceable under applicable state law).
Furthermore, according to the proposed regulations, the amount deductible will be lowered by the estate’s right to contribution or reimbursement.
The proposed regulations establish a clear-cut principle that a decedent’s agreement to guarantee a legitimate debt of an entity over which they exercised control (as defined by IRC Section 2701(b)(2)) at the time of the guarantee) satisfies the requirement that the agreement is made in exchange for adequate and full consideration in money or money’s worth.
In contrast, the proposed regulations state that this requirement is also met if, at the time the guarantee is given, the maximum liability of the decedent under the guarantee did not exceed the fair market value of the decedent’s interest in the entity.
This leads to the unfavourable implication that, despite the decedent’s potential ownership of a sizable stake in the entity, the personal guarantee of the decedent in situations that do not fall under these circumstances may not result in an estate tax deduction.
This appears to be way too restrictive, and it’s anticipated that comments on the proposed regulations will address this.
