As a practitioner who assists executors with completing and filing the Form 706 United States Estate (and Generation-Skipping Transfer) Tax Return (“Form 706”), Internal Revenue Code (“Code”) Section 2051 defines the taxable estate as the value of the gross estate less deductions taken under Code Sections 2053-2058. Section 2053 deals with deductions for funeral expenses, administration expenses, claims against the estate, and unpaid mortgages, or any indebtedness in respect of, property includible in the value of the decedent’s gross estate. The Internal Revenue Service (“IRS”) published final regulations for Code Section 2053 in 2009 (“2009 Regulations”) limiting the deduction for claims and expenses to the amounts actually paid in settlement or satisfaction of the item, with exceptions for ascertainable amounts, claims against the estate, and indebtedness. The 2009 Regulations contained reservations for future guidance on the application of present-value principles in determining the amount of the deduction under Code Section 2053. Among other items that include guidance on the deductibility of interest expense accruing on tax and penalties the estate owes, interest and expense accrued on certain loan obligations incurred by the estate, and amounts paid under a decedent’s personal guarantee, the recently promulgated proposed regulations (REG-130975-08) address proper use of present-value principles in determining the amount that an estate may deduct for funeral expenses, administration expenses, and certain claims.
The preamble to the proposed regulations makes clear that they sought to address the issue of the proper amount deductible under IRC 2053, especially in situations when the estate pays the obligation over time. According to Section 20.2053-3(d)(2) of the proposed regulations, interest on a loan entered into by an estate to facilitate payment of the estate’s tax or the administration of the estate may be deductible if the following are true: (1) the interest expense arises from an instrument or contractual arrangement that constitutes indebtedness under the applicable income tax regulations and principles of federal law; (2) the interest expense and loan are “bona fide in nature bases on all the facts and circumstances” and (3) the loan terms are “actually and necessarily incurred in the administration of the decedent’s estate.” The proposed regulations then expand on these concepts by including a list of eleven non-inclusive factors that collectively may support a finding that the requirements have been satisfied.
The preamble to the proposed regulations explains that estates often need additional time to pay every deductible claim and expense, but that most pay nearly all their ordinary expenses within the three-year period immediately following the decedent’s date of death, and thereby “strikes an appropriate balance between benefits and burdens” by setting the time during which the estate may deduct the entire value of a claim at three years. The proposed regulations amend the 2009 Regulations and require the estate to discount to present value amounts paid after the third anniversary of the decedent’s death and refer to that time from the date of death to the third anniversary as the “grace period.” While the proposed regulations make sense and may provide a more economically accurate deduction, they substantially undercut a previously significant payment tool for illiquid estates: the Graegin note.
The Graegin note was named after the case in which it was first recognized as valid, Estate of Graegin v. Commissioner, T.C. Memo 1988-477. A Graegin loan has a set interest rate, the taxpayer may elect a fixed term of years, and the note prohibits prepayment of principal or interest. Because of the fixed and determinable amount of the interest payment, the Graegin Court and numerous other cases that followed allowed a dollar-for-dollar estate tax deduction for the payment of interest, including future interest. There was no limit on the term of the note which meant that the estate could receive an upfront deduction for interest that it wasn’t going to pay for several years. This technique allowed executors of estates faced with a liquidity problem to use a properly structured Graegin note to borrow the cash necessary to pay the estate tax or otherwise administer the estate. The technique usually also had the added benefits of allowing the family to keep more assets, eliminating a fire sale to raise funds quickly, and reducing the size of the taxable estate.
Prior to the proposed regulations, the power of using a Graegin note was that the estate could deduct the full amount, dollar-for-dollar of the interest paid in the future over the term of the loan on Form 706; no present-value reduction was necessary. For example, if an estate borrowed $10 million at 5% interest on a 10-year note, the estate could structure the loan to defer all principal payments and interest until year 10 at which time the estate would make a balloon payment. On Form 706 the estate could deduct that $5 million future interest payment ($10 million borrowed * .05 interest rate * 10 years), thereby further reducing the taxable estate and saving the estate an additional $2 million ($5 million * .40 tax rate). In many ways, the Graegin loan was a home run. Of course, the transaction had to have economic substance which included documenting the estate’s need for liquidity, providing detail regarding the structure of the note, calculating the interest due, and confirming that the note conformed to market standards.
While these proposed regulations have yet to become final, it seems that the Graegin note is destined to go the way of Blockbuster video stores. The present value and interest limitations contained in the proposed regulations restrict the amount deductible under a Graegin arrangement, if allowed at all. There may a small window during which the estates can continue to benefit from the use of a Graegin structure, but it’s closing fast. Note that the proposed regulations will apply to the estates of decedents dying on or after the date the final regulations are published in the Federal Register.