IRS releases draft estate administration regulations
On June 28, 2022, the Internal Revenue Service released proposed regulations (proposed regulations) under Section 2053 of the Internal Revenue Code. (Federal Register :: Guidelines under Section 2053 regarding the deduction of interest expense and amounts paid under a personal guarantee, certain substantiation requirements, and the applicability of present value concepts). They: (1) provide guidance on the use of present value principles to determine the amount deductible by an estate for funeral expenses, administration costs and certain claims against the estate; (2) provide guidance on the deductibility of accrued interest expense on taxes and penalties owed by an estate and accrued interest expense on certain loan obligations incurred by an estate; (3) modify and clarify the requirements to substantiate the value of a claim against an estate that is deductible in certain circumstances; and (4) provide guidance on the deductibility of amounts paid under a deceased person’s personal guarantee.
Three-year grace period
The proposed regulations provide guidance on applying present value principles to determine the amount deductible under Section 2053 of the Internal Revenue Code. The preamble to the proposed regulations states that limiting the deductible amount to the present value of amounts paid after a post-death period will more accurately reflect the economic realities of the transaction, the true economic cost of that expense or claim, and the amount not transmitted to the beneficiaries of the estate. Accordingly, the proposed regulations incorporate present value principles to determine the deductible amount for claims and expenses, subject to certain exceptions (including for outstanding principal of mortgages and certain other debts).
Specifically, the proposed regulations require the calculation of the present value of the amount of a claim or deductible expense that is not paid or payable on or before the third anniversary of the date of the deceased’s death, defined as the “grace period”. The discount rate to be used is the applicable federal rate determined under IRC Section 1274(d) for the month in which the date of the deceased’s death occurs, compounded annually.
The proposed regulations require that a supporting statement be filed with the Form 706 tax return showing any present value calculations. In addition, they provide that the expected date or dates of payment must generally be indicated in a written appraisal document.
Interest on tax and penalties due
According to the preamble, the IRS has determined that interest payable on unpaid estate tax under an extension under IRC Section 6161 or a deferral under IRC Section 6163 is necessarily incurred in the administration of the estate. In addition, the proposed regulations recognize that interest on estate tax installment payments that is permitted under section 6166 is not deductible for estate tax purposes – which already seemed clear. , but which presumably lent itself by its reiteration as part of the regulation’s proposal to create the phrase “interest not referred to in section 6166” to describe all other situations in which interest may be payable in within the framework of the administration of an estate.
The proposed regulations consider that where interest not in accordance with section 6166 has accrued on unpaid taxes and penalties in connection with an underpayment of tax or a deficit and is attributable to the negligence of an executor, non-compliance with rules or regulations or fraud with intent to evade tax, interest expense is not an expense actually and necessarily incurred in the administration of the estate. As a result, interest on taxes is not deductible to the extent the interest expense is attributable to the negligence of an executor, failure to comply with applicable rules or regulations, or fraud with intent to evade tax.
Interest on certain loan obligations
The proposed regulations target the use of “Graegin loans” (Graegin Estate c. Commissioner, Memo TC. 1988-477) and the perceived attempts by estates to “concoct” the illiquidity to be resolved through loan agreements with related parties that prohibit prepayment of principal and interest before the maturity date of the loan. While the IRS’ concern is understandable, the prescription proposed by the proposed regulations goes too far.
The preamble recognizes that some estates face real liquidity problems that require them to find a way to satisfy their debts, and incurring a loan obligation on which interest accrues may be the only or best way to obtain the cash. required. However, if cash has been created intentionally (whether in estate planning or by the estate having knowledge or reason to know of the estate tax payable) prior to the creation of the loan obligation to pay the expenses and debts of the estate, the underlying loan may be in good faith but (according to the preamble) ” not actually and necessarily engaged in the administration of the estate”. (Preamble, p. 15; italics added)
The proposed regulations provide that interest expenses are deductible only ifamong other things, the terms of the loan are actually and necessarily incurred in the administration of the estate of the deceased and are essential the proper settlement of the estate of the deceased. In addition, the proposed regulations provide a non-exclusive list of factors to be considered in determining whether the interest charges payable under such an estate loan obligation meet the applicable requirements. One is whether the loan obligation is entered into by the executor with a lender who is not a significant beneficiary of the deceased’s estate (or an entity controlled by such a beneficiary) to a when there is no alternative available to obtain the necessary liquid funds to meet estate obligations. The preamble gives an example where the necessity of the loan or one of the conditions of the loan is designed to generate or increase the amount of a deduction for the interest expense – in this case the interest is not deductible. Additionally, if the loan obligation involves an extended loan term with a one-time lump sum payment that does not match the estate’s ability to repay the loan, the preamble states that accrued interest on the loan is not necessarily incurred in the administration of the estate (and is therefore not deductible).
The IRS appears to extend its scrutiny not only to actions taken after death that can create illiquidity, but also to estate planning during the deceased’s lifetime that produces illiquidity after death. This ignores the fact that taxpayers may have important non-tax reasons for structuring their assets in such a way as to be illiquid, including to ensure that subsequent generations do not sell their inherited business interests that the deceased has spent his life building from scratch. An Irrevocable Life Insurance Trust (ILIT) is commonly used to create a source of cash outside of the deceased’s taxable estate, with the ILIT trustee often loaning the funds obtained from the insurance proceeds to the executor to help fund the payment of inheritance tax. The proposed regulations will need to be amended to expressly exempt such pre-death financing arrangements (which may also be made through business entities) from limiting an estate’s interest deductions.
Substantiation of the value of a claim against an estate
According to the preamble, the IRS has reconsidered the application of the “qualified appraiser” and “qualified appraiser” requirement in this context. Instead, the proposed settlements require a written valuation that adequately reflects the current value of the claim when the Form 706 tax return is completed. The present value of the claim must take into account post-death events that occurred before the time a deduction is claimed as well as events that can reasonably be expected to occur.
Deductibility of amounts paid under a personal guarantee
The proposed regulations provide that a claim based on a deceased person’s personal guarantee of the debt of another is a claim based on a promise and, therefore, must meet the applicable requirements. Specifically, the warranty must have been in good faith and in exchange for adequate and full consideration in money or monetary value (as opposed to gratuitous, even if enforceable under applicable state law). In addition, the proposed regulations provide that the right of contribution or refund of the estate will reduce the deductible amount.
The proposed regulations provide a clear rule that a deceased’s agreement to guarantee a bona fide debt of an entity in which the deceased had control (as defined in IRC Section 2701(b)(2)) at the time of the guarantee satisfies the requirement that the agreement be in exchange for adequate and full consideration in money or money’s worth. Alternatively, the proposed regulations provide that this requirement is also met if, at the time the guarantee is given, the deceased’s maximum liability under the guarantee does not exceed the fair market value of the deceased’s interest in the entity. This creates a negative inference that the personal guarantee of the deceased in circumstances which fall outside these circumstances may not give rise to an estate tax deduction, even though the deceased may have had a substantial interest in the entity. This seems far too restrictive, and the comments on the proposed regulations are expected to address this.
Kevin Matz is a partner at the law firm ArentFox Schiff LLP in New York.