Estate of Vincent J. Duncan (October 31, 2011), illustrates the successful use by the taxpayer of what estate tax lawyers refer to as a Graegin loan, named after one of the first cases to approve the technique. The expenses incurred in administering the estate of a decedent may be deducted from the amount of the gross estate to determine the taxable estate upon which the estate tax is imposed. If an estate can demonstrate that it must borrow money in order to pay the estate taxes that it owes, then the full amount of the interest that will be due over the term of the loan can be deducted from the gross estate as an administration expense.
In the Duncan case, the estate demonstrated that its assets were illiquid and could not be sold to pay the estate tax due. The estate (held through a trust that was revocable up to the time of the taxpayer's death) borrowed $6,475,515 from an irrevocable trust that had been set up for the decedent by his father. Northern Trust was the trustee of both trusts and following the decedent's death his children were the beneficiaries of both trusts. Interest on the loan was accrued and compounded and all principal and interest were payable in a single installment after 15 years. The loan prohibited the prepayment of interest or principal. The interest rate was set at 6.7% per annum at a time when the applicable federal rate was 5.02% and the prime rate was 8.25%. The interest rate was recommended by Northern Trust's banking department as being a market interest rate for this type of loan in October of 2006 when the loan was made. On its estate tax return, the estate deducted $10,653,826 for the interest that would be due on the loan at the end of its 15 year term.
The IRS raised several objections to the loan including that it was not bona fide because the lender was a trust with the same trustee and beneficiaries as the borrower. The Tax Court rejected this argument because under applicable state law the trustee had a duty to administer each trust individually and without regard for the fact that the two trusts were essentially related. This meant that both the lending and borrowing trusts would be obligated under the law to recognize and enforce the terms of the loan.
The IRS next argued that the term was longer than needed because the borrower generated enough income in 3 years to pay off the loan. The court declined to second guess the judgment of the borrower's advisors who recommended the 15 year term because the trust's revenue stream was tied to oil and gas prices, which were unpredictable. The court also found that the loan was necessary because without the loan the trust would have to sell illiquid assets at depressed prices in order to pay the estate taxes. The cost incurred to protect against a forced sale is a reasonable expense of estate administration.
The IRS also challenged the interest rate. It argued that because the trust that was the lender and the trust that was the borrower had the same beneficiaries, the interest rate should not be higher than the applicable federal rate. The court rejected this argument as well, finding that the trust's cost of borrowing should objectively be higher than the applicable federal rate, which reflects the government's cost of borrowing.
The IRS then argued that the total amount of interest that would be paid over 15 years was uncertain because the loan could be prepaid. The IRS acknowledged that the note prohibited prepayment, but argued the restriction had no significance because the trustee and beneficiaries of both trusts were the same. The court rejected this argument as well, again noting the trustee was required to administer the trusts separately and in each case in the best interests of the beneficiaries of that particular trust. The court found that the two trusts had opposing interests regarding prepayment. If interest rates increased, it would not be in the best interest of the borrowing trust to prepay the loan. If interest rates decreased, it would not be in the best interest of the lending trust to accept prepayment.
The key to successfully deducting all of the interest that will accrue on a loan obtained to pay estate taxes is being able to show that without such a loan, assets would need to be sold at artificially depressed prices in order to raise funds to pay the tax.
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