GRAEGIN LOANS – DO THE MATH!

There is an often an estate tax advantage to an estate borrowing funds, especially from related parties. If the estate is in a high estate tax bracket, it can deduct the interest, and thus save estate taxes. For example, if the estate is solidly in or above the 45% tax bracket, then the estate tax savings are at least 45% of the interest cost. The recipient will have to pay income taxes on the interest income, but maximum income tax rates in this example would be higher than the estate tax savings (except perhaps in some states with high state income tax rates), so a net tax savings would result. If the lender is a tax-exempt entity such as a family foundation, then the income taxes are almost entirely eliminated, enhancing the overall tax savings (even though the savings accrue for charitable purposes).

This is what the Estate of Henry Stick did – it borrowed funds from a family foundation (well, in this case, the remainder beneficiary actually did the borrowing). However, the estate failed to appreciate the simple mathematics at work that address the estate tax deduction, and thus lost its estate tax deduction for the interest paid when the Tax Court reviewed the matter.

Treas. Regs. §20.2053-3(a) requires that estate tax deductions must be actually and necessarily incurred, to be deducted. In the context of interest expense for borrowings by the estate, the Tax Court looks to see if the borrowing was needed by examining whether there are enough liquid assets to pay the estate tax liability and other administrative expenses. In the Stick Estate, the estate had approximately $1,953,617 in liquid assets. Putting together its administrative expenses and federal and state estate taxes, these obligations totaled $1,723,799. Thus, at least in the absence of other compelling circumstances, there was no need for the estate to borrow funds. In a short and sweet opinion, the Tax Court noted the excess of liquid assets over obligations and denied the interest deduction for the loan taken.

Estate of Henry H. Stick, TC Memo 2010-192