In the too-good-to-be-true department of estate planning, it is sometimes possible to take a loan from a family trust or other entity controlled by the decedent and family members to pay estate tax and deduct the interest on the estate tax return. Such loans are very useful when the estate or trust needs liquid assets and money is available from other sources to pay estate taxes.
More than just a convenience, these somewhat incestuous loans have financial advantages: the interest can be deducted immediately even though it won’t be paid for many years, and the interest expense deduction reduces the estate tax owed.
These loans are called Graegin loans because they were pioneered in Estate of Cecil Graegin, TC Memo 1988-477. In Graegin, an estate holding stock in a closely-held corporation borrowed $200,000 from the corporation to pay estate tax and deducted $450,000 from the taxable estate for interest due in 15 years. Under IRC §2053, an estate is allowed an estate tax deduction for administration expenses and claims against the estate.
The Graegin court held that the interest expense was “actually and necessarily” incurred under Treas Reg §20.2053-3(a) to avoid a forced liquidation of estate assets. The loan prohibited prepayment, so the court concluded that the amount was “ascertainable with reasonable certainty” under Treas Reg §20.2053-3(b).
Ah, but such a great deal doesn’t go uncritcized. Some recent decisions have raised doubts about the efficacy of this technique. See Samuel P. Black (2009) 133 TC 340 (court disallowed claimed $20 million for interest to be paid on maturity of 5-year promissory note for repayment of loan from family limited partnership (FLP) funded by publicly traded stock because estate had no means to repay loan but to have FLP sell the stock); Estate of Henry H. Stick, TC Memo 2010-192 (court disallowed deduction for interest on loan from family foundation controlled by decedent because estate’s liquid assets exceeded its total obligations).
But Graegin loans are back on track with the latest Tax Court decision in Estate of Vincent J. Duncan, Sr., TC Memo 2011-255. The court allowed a $10.6 million deduction for accrued interest on a $6.5 million loan to the decedent’s trust from a trust created by decedent’s father. The two trusts had same trustees and the same beneficiaries, although there were subtle differences that could become important in distinguishing the decision on less favorable facts.
Like the original Graegin loan, the Duncan loan had a 15-year repayment period and a prepayment prohibition clause. The court held that the terms of the loan were reasonable and the trustees had a fiduciary obligation to repay the loan on schedule so prepayment “would definitely not occur.”
Other recent decisions, albeit district court decisions without much authority in the Ninth Circuit, have been favorable toward Graegin loans. See Keller v U.S. (SD Tex 2010) 2010-2 USTC ¶60,605, 106 AFTR2d 6309; Estate of Murphy (WD Ark 2009) 2009-2 USTC ¶60,583, 104 AFTR2d 7703.
The takeaway here: Consider a Graegin loan when the estate or trust has illiquid assets and money is available from other sources to pay estate taxes.
Check out a detailed discussion of the Duncan decision in the December issue of the Estate Planning & California Probate Reporter. On Graegin loans, turn to CEB’s Drafting California Revocable Trusts §4.123B. Also check out CEB’s California Trust Administration §12.42A in the forthcoming February 2012 update.
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