Recent tax case approves use of related party loans to reduce and fund estate taxes

The expected significant change in the estate tax at the end of 2012 should cause most affluent persons to engage in estate planning. Usually, this will involve an irrevocable trust. One issue that invariably arises is how a future estate tax will be paid for those assets that have not been removed from the estate. A recent tax case provides relaxed guidelines for the use of related party loans, with an administrative cost deduction for the interest.

Generally, courts have found interest to be deductible as an estate administration expense if it meets the requirements of IRC 2053(a)(2) and the related regulations. The leading initial case on this subject is the Estate of Graegin vs. Commissioner, T.C. Memo 1988 – 477. In Graegin, the estate had a liquidity problem that was addressed by borrowing from the decedent’s closely-held business on a 15-year, unsecured, single-payment note. Voluntary repayment or an involuntary acceleration was prohibited. The estate claimed an immediate interest deduction for what would be paid at the end of the fifteen-year period. The IRS disallowed the deduction on the grounds that the debt was not ordinary and necessary, that the loan was not a true loan, and because the interest was not reasonably certain to be paid. In Graegin, the Court allowed the deduction.

A recent case, Estate of Duncan v. Commissioner, T.C. Memo 2011-255 explored a fact pattern in which the debtor (a revocable trust) and lender (an irrevocable trust) had the same trustees and beneficiaries, and so were identical in terms of interests and control. The Tax Court upheld the administration cost deduction. We described the case’s details and additional background in this article.

The reaffirmation of the Graegin conclusion using the facts of the Duncan case provides flexibility to estate administration, and should be of great relief to those who are planning their estates.


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