Do you have clients whose estates face a liquidity crisis because they’re loaded with stock in a family company or other illiquid assets? A Graegin loan may be just the technique you need to prevent unwanted liquidation of estate assets to pay estate taxes and other expenses. Add life insurance and the Graegin loan’s positive impact on estate liquidity can be levered up significantly.
When Are Loan Expenses Deductible by an Estate?
To be deductible, loan expenses must be allowable by the laws of the state where the estate is being administered. Additionally, the regulations require that the expense be “actually and necessarily, incurred in the administration of the decedent’s estate.” [Treas. Reg. §20.2053-3(a)] The regulations go on to specify that “administration of the decedent’s estate” means the following activities: The collection of assets, payment of debts, and distribution of property to the persons entitled to it. One such valid reason is the prevention of forced sale of assets.
The Graegin Case
In Graegin [Graegin Est. v. Commissioner, 56 TCM 387 (1988)], Cecil and Helen Graegin married late in life. As part of an antenuptial agreement, they created two trusts—Cecil’s trust and Helen’s trust. Cecil’s trust was funded with 5,130 shares of Graegin Industries Inc. stock, worth $564,300. Under Cecil’s trust, after his death the Graegin Industries stock was to be distributed to his chosen beneficiaries, including children and grandchildren from a previous marriage.
Cecil predeceased Helen. After Cecil died and his estate paid its non-estate tax debts, there was only about $20,000 in liquid assets left to pay his $204,218 estate tax bill. Rather than sell the Graegin stock to pay the estate tax bill, his executors borrowed $204,218 to pay the estate tax bill from Graegin Corp., a wholly owned subsidiary of Graegin industries.
The unsecured note bore 15 percent interest per annum, but interest and principal were to be paid in a single payment 15 years later. The 15-year term was equal to Helen’s expected life span. They anticipated that dividends paid on the stock to Cecil’s trust, and assets remaining in Helen’s trust at her death would be used to repay the loan.
On Cecil’s estate tax return, his executor deducted as an administration expense the $459,491—the amount of interest that would be paid on maturity of the note.
Is the Interest Expense on a Graegin Loan Deductible?
Yes, if the transaction is structured properly the interest is currently deductible even if it won’t be paid for many years. In the Graegin case, the court decided that the interest expense was actually incurred and could be estimated with a high degree of certainty. The court also determined that the loan was bona fide and necessary expense of the estate. Although Cecil’s son Paul was both an executor of Cecil’s estate and 97 percent owner of Graegin Corp.—putting him on both sides of the transaction—the court believed that Paul intended to enforce the note by its terms.