An Unreasonable Burden?

One of the reasons often given in support of the elimination of the estate tax is the economic burden it imposes upon the closely-held business; specifically, the requirement that the 40% federal estate tax be satisfied within nine months of the death of the business owner. The imposition of a state “death tax,” such as New York’s 16% tax, only exacerbates the problem.

Under these circumstances, or so the argument goes, a decedent’s estate would be forced to sell the business in what proponents of estate tax repeal describe as a “forced sale,” thus depriving the decedent’s family of an opportunity to continue the business, and resulting in the loss of the value created by the decedent over a lifetime of hard work.

Truth be told, where the decedent’s business represents the most valuable, and perhaps most illiquid, asset in the decedent’s estate, how else is the estate to raise the funds needed to pay the estate tax in such a short period of time?

Plan Ahead

Thankfully, many business owners begin to address this issue while they are still alive. Because the first step in calculating the estate tax is determining the value of the gross estate, a business owner who is able (for example, under the terms of a shareholders’ or operating agreement) and willing can make gifts of interests in the business to family members or to trusts for their benefit, thereby removing the appreciation in the value of those interests from his gross estate.

Although the reduction of one’s gross estate goes a long way in managing the estate tax burden, it has its limits – planning for deductions is necessary, especially for transfers to a spouse who may or may not be involved in the business, but who will require the revenue from the business. However, depending upon the value of the business, this approach will only defer the payment of the tax.

Insurance

In recognition of the foregoing limits, business owners will often acquire insurance on their lives, hopefully in an irrevocable life insurance trust. These funds may be used to purchase the decedent’s business interest, and the terms of the trust would then provide for the disposition of the interest.

In other situations, the business itself, or the decedent’s fellow partners or shareholders, may acquire life insurance on the decedent; pursuant to the terms of a shareholders’, partnership, or other buyout agreement, the owner/beneficiary of the policy would use the insurance proceeds to acquire the decedent’s business interest from his estate.

Where life insurance is not acquired, or the insurance acquired is insufficient, or where the insured is, for whatever reason, not insurable, the decedent’s estate may nevertheless have other options available to it.

Installment Payments

Under one statutory provision, which was enacted for the express purpose of helping to preserve closely-held businesses, the estate of a deceased owner may elect to pay the estate tax attributable to the value of the decedent’s interest in the closely-held business over a period of ten years. Furthermore, these payments are due beginning five years after the estate tax return is filed (with only interest payable until the fifth year). In this way, the profits from the business itself may assist the estate is satisfying the tax liability.

In order to qualify for this benefit, the value of the decedent’s interest in the closely-held business must exceed 35% of the decedent’s adjusted gross estate (which may restrain a lifetime gifting program), and the decedent must have owned at least a 20% interest in the business.  In addition, the business entity must be carrying on an active trade or business (as opposed to a passive or portfolio investment-type activity).

However, the estate is not in the clear just yet; for example, if any portion of the interest in the closely-held business is sold, or if money is withdrawn from the business, and the aggregate value of such transactions equals or exceeds 50% of the value of the business, then the extension of time for payment of the estate tax ceases to apply, and the IRS may demand payment of the unpaid portion of the estate tax.

The logic behind this acceleration rule is fairly obvious.  If the interest is sold, and the estate thereby becomes liquid, then the justification for installment payments – to preserve the interest in the closely-held business – no longer exists.

“Graegin Loans”

In other circumstances – for example, where the estate does not qualify for installment reporting, or where it prefers to pay the tax upfront – the estate may be able to borrow the necessary funds from the decedent’s business (which may have to borrow the funds from an institutional lender). Provided this borrowing represents a bona fide indebtedness between the business and the estate, and provided the interest to be paid by the estate in respect of the loan can be ascertained with reasonable certainty (for example, the loan terms provide that it may not be prepaid as to principal or interest), the estate will be able to deduct the total amount of interest payable under the loan – for purposes of determining the estate tax liability – as an administration expense incurred to prevent the financial loss that may otherwise occur as a result of a forced sale of the business in order to pay the estate tax.

Is the Loan “Necessary”?

A recent decision by the Court of Appeals for the Eleventh Circuit considered the interest deduction claimed by Decedent’s estate in connection with a loan from a controlled LLC.

At his death, Decedent owned 46.9% of Company’s voting stock and 51.5% of its nonvoting stock. His children owned most of the remaining stock, either directly or through trusts, while other family members and trusts held the remaining shares.

The Decedent’s Revocable Trust held a 50.50% interest in LLC on the date of his death, 46.94% of which was a voting interest and 51.59% of which was a nonvoting interest. The Revocable Trust comprised the majority of the assets of Decedent’s Estate, with the Trust’s interest in LLC being its primary asset. LLC was flush with liquid assets at the time of Decedent’s death.

The Loan

The Estate’s remaining liquid assets, however, were insufficient to pay its tax liability. The fiduciaries of the Estate declined to direct a distribution of the Revocable Trust’s interest in LLC to pay the estate tax liability, believing that immediate payment would hinder LLC’s plans to invest in operating businesses.

As a result, the trustees instead obtained a large loan from LLC in exchange for a promissory note bearing a market interest rate, though no payment was due for 18 years, at which point principal and interest were scheduled to be repaid in 14 annual installments. Prepayments were not permitted under the terms of the loan, and the projected interest payments were determined with reasonable certainty.

Because the Revocable Trust’s primary asset was its interest in LLC, it anticipated that the loan would be repaid with distributions from LLC, which had significant liquid assets at the time of the loan.

IRS Challenges the Estate Tax Return

When the Estate filed its estate tax return, it claimed a large deduction, as an administrative expense, for the interest payable on the loan.

The IRS determined a significant estate tax deficiency, in large part due to its determination that the interest payments were not properly deductible.

The U.S. Tax Court agreed, holding that Estate was not allowed to deduct the projected interest expense on the loan from LLC to the Revocable Trust. In reaching this holding, the Tax Court concluded that the loan was not necessary to the administration of the estate because, at the time the loan was made, LLC had substantial liquid assets and the Revocable Trust had a sufficient voting interest in LLC to force a pro rata distribution by the LLC in the amount of the debt. The Tax Court also rejected the Estate’s argument that the loan was preferable because a distribution would have depleted the LLC of cash that could have been used to purchase additional businesses; the Court noted that the loan also depleted the LLC of cash.

Additionally, the Tax Court observed that the loan would ultimately be repaid using the Revocable Trust’s distributions from LLC, such that it merely delayed the use of such distributions to pay the Estate’s tax liability. Further, it stated that the loan repayments were due many years after Decedent’s death, which hindered the proper settlement of the Estate.

The Estate appealed this decision to the Eleventh Circuit.

Administration Expense?

An estate is permitted to deduct expenses that are actually and necessarily incurred in the administration of a decedent’s estate. Expenditures that are not essential to the proper settlement of the estate, but that are incurred for the individual benefit of the decedent’s heirs, may not be taken as deductions. Expenses incurred to prevent financial loss to an estate resulting from forced sales of its assets to pay estate taxes are deductible administration expenses. Conversely, interest payments are not a deductible expense if the estate would have been able to pay the debt using the liquid assets of one of its entities, but instead elected to obtain a loan that will eventually be repaid using those same liquid assets.

The Court began by noting that an estate’s interest payments on a loan may be a necessary expense where the estate would have otherwise been forced to sell its assets at a loss to pay the estate’s debts. The Court described the case of an estate that held a substantial number of shares of voting stock of a closely-held corporation, but lacked sufficient liquidity to pay its tax liability; as a result, the estate obtained a loan from a third party rather than selling its voting stock. The interest payment in that case was necessarily incurred and properly deducted as an administrative expense, the court stated, because the estate consisted of largely illiquid assets and, had it not obtained the loan, it would have been forced to sell its assets on unfavorable terms to pay the taxes.

The Court observed, however, that an interest deduction is properly denied if the estate can pay its tax liability using the liquid assets of an entity, but elects instead to obtain a loan from the entity and then repays the loan using those same liquid assets.

The court then determined that the “loan structure, in effect, constituted an indirect use of [the decedent’s] stock to pay the debts . . . and accomplished nothing more than a direct use of that stock for the same purpose would have accomplished, except for the substantial estate tax savings.” It observed that those cases that permitted the interest deduction involved loans that were necessary to avoid the sale of illiquid assets, and did not involve the sale of the lender’s stock or assets to pay the borrower. Finally, because the petitioner was a majority partner in the limited partnership, “he was on the both sides of the transaction, in effect paying interest to himself,” resulting in the payments having no effect on his net worth aside from the tax savings.

Interest payments are not necessary expenses, the Court stated, where: (1) the entity from which the estate obtained the loan has sufficient liquid assets that the estate can use to pay the tax liability in the first instance; and (2) the estate lacked other assets such that it would be required to eventually resort to those liquid assets to repay the loan.

The Estate’s Liquidity

If the Estate had been forced to sell its interest in LLC, it would have been required to do so at a loss. Tax Court decisions are clear that interest payments on loans constitute a necessary expense if the estate’s only other option is a forced sale of assets at a loss. Therefore, if the Estate’s only option had been to redeem the Revocable Trust’s interest in the LLC, then the loan would have been necessary and the interest payments on the loan would be a necessary expense. However, because the Revocable Trust had voting control over LLC, and because LLC had substantial liquid assets, the Revocable Trust could have ordered a pro rata distribution to obtain these funds and pay its tax liability.

According to the Court, a loan is not unnecessary merely because the estate had access to a related entity’s liquid assets and could have used those assets to pay its tax liability. Instead, a loan is unnecessary if the estate lacks any other assets with which to repay the loan, and inevitably will be required to use those same assets to repay it. Stated differently, where the estate merely delays using the assets to repay the loan rather than immediately using the assets to pay the tax liability, the loan is an “indirect use” of the assets and is not necessary.

The loan in the present case was an “indirect use” of funds and was not necessary. Aside from the Revocable Trust and the Trust’s interest in LLC, the Estate lacked sufficient funds to repay the loan. The Estate’s Loan repayment schedule was designed to enable the Trust to repay the loan out of its distributions from LLC. Accordingly, the Revocable Trust’s distributions from LLC would be used to satisfy the Estate’s tax obligations regardless of whether the Estate paid its tax liability immediately or obtained a loan and then repaid the tax liability gradually. Further, LLC would be paying disbursements to the Revocable Trust only to have those payments returned in the form of principal and interest payments on the loan. The same entity is on both sides of the transaction, resulting in LLC “in effect paying interest to” itself.

Thus, the loan had no net economic benefit aside from the tax deduction. This further demonstrated that the loan was not necessary.

Decisions, Decisions

It will behoove the future fiduciaries and beneficiaries of a taxpayer’s estate – not to mention the taxpayer himself – to consider how the estate tax on the taxpayer’s estate will be paid. As is the case with gift and estate planning, there is likely no single “silver bullet” solution; rather, different strategies may be combined to produce a payment plan that will be optimal for the decedent’s estate given the nature of his business and other assets, and the cash flow they generate.

If a loan is to be considered, then in addition to the substantive issues described above, the interested parties will have to weigh the economic benefit of preserving the estate’s assets against the economic cost of taking and servicing a loan.