Take-Away: As is often the case, the IRS’s Proposed Regulations which are intended prohibit an estate tax deduction of some ‘concocted or contrived’ estate expenses, are so broad as to threaten some common estate plan steps where the estate’s  illiquidity  is a result of non-tax reasons.

Background: In late June, 2022, the IRS released Proposed Regulations with regard to estate tax deductions for funeral expenses, estate administration expenses, and some claims against a decedent’s estate. Those Proposed Regulations also provide guidance on the deductibility of interest expense that accrues on taxes and penalties owed by a decedent’s estate. While federal estate tax exposure has for several years now taken a ‘back seat’ to income tax planning due to the very large and increasing applicable exclusion amount for federal transfer taxes, we may soon find ourselves refocusing on minimizing federal estate and GST taxes when the applicable exclusion amount is cut in half beginning in 2026. Which is why these Proposed Regulations will have more relevance as 2026 nears. A couple of provisions to be aware of in these Proposed Regulations are summarized below.

Deductible Interest Expense: The Proposed Regulations provide that the interest expense incurred by a decedent’s estate is deductible only if, among other things, the loan terms are “actually and necessarily incurred in the administration of the decedent’s estate and are essential to the proper settlement of the decedent’s estate.” This is the standard that an estate must satisfy before interest obligations are deductible by the estate in computing the estate’s federal estate tax liability. Some of the factors that the Regulations set forth  whether an interest obligation will be deductible include: (i) is the lender a substantial beneficiary of the estate, or controlled by that beneficiary?; (ii) is there an available alternative to obtain necessary liquid funds to satisfy estate obligations?; (iii) is the loan needed or ‘contrived?’ [a word used in the Regulations’ Preamble]. Along these lines, the Regulations note that if a loan obligation carries an extended term with a single balloon payment, that loan will not correspond to the estate’s ability to satisfy the loan, i.e. the loan ‘is not necessarily incurred in the administration of the estate and therefore is not deductible.’

Present Value and 3-Year Grace Period: The Proposed Regulations require that deductible  debts or expenses of a decedent’s estate to be paid in the future will be subject to present valuation principles. Specifically, the Proposed Regulations provide that the present value of the amount of a deductible claim or expense against the decedent’s estate that is not paid, or to be paid, on or before the third anniversary of the decedent’s date of death, must be provided. This 3-year window where the present value of the debt or expense owed by the decedent’s estate is not required to be furnished, is referred to as the grace period. Consequently, if a debt or expense that is due beyond 3 years from the decedent’s death, then the present values of those debts or expenses must be used to calculate the decedent’s federal estate tax liability.

Calculation and Reporting: The applicable federal rate of interest (AFR) for the month of the decedent’s death must be used for purposes of the present valuation discount. [IRC 1274(d).] This is then compounded annually. A supporting statement must be filed with the Form 706 estate tax return, on which the calculation of the debt or expense’s present value must be furnished. The expected date or dates of payment of the debt or expense by the decedent’s estate must be identified in the written appraisal report which prepared by a qualified appraiser. Thus, the complexity of an already complex tax return just got worse, and the expense to prepare present value calculations of debts and expenses just got greater.

Interest Expense on Tax and Penalties: The Proposed Regulations claim that the amount of interest that is payable on the unpaid federal estate tax in connection with an extension to pay [IRC 6161] or the deferral to pay federal estate taxes [IRC 6163] is necessarily incurred in the administration of the decedent’s estate. Also, the Proposed Regulations take the position  that interest paid on estate tax installment payments that are authorized [IRC 6166, think agricultural and closely held business interests] are not deductible for estate tax purposes. With respect to interest payments that are not associated with IRC 6166, the Proposed Regulations provide that if the interest has accrued on an unpaid tax or penalties in connection with an underpayment of tax deficiency, and it is attributable to a Personal Representative’s negligence, disregard of the rules and Regulations, or fraud with the intent to evade the tax, the interest expense is not an expense actually and necessarily accruing in the administration of the estate. Consequently, the interest charged on taxes is not deductible to the extent that the interest is attributable to a finding that there was negligence, disregard of applicable rules and Regulations, or fraud with the intent to pay tax.

Liquidity and Illiquidity: The Proposed Regulation take a direct shot at what are called Graegin Loans [Estate of Graegin, Tax Court 1988-477.] Clearly the IRS views Graegin loans as part of a scam to ‘concoct’ [another word is taken directly from the Preamble] estate illiquidity, specifically in the form of an estate that has to borrow funds to pay federal estate taxes under loan agreement with related parties, the terms of which prohibit the prepayment of loan principal and interest prior to the loan’s maturity date. These loan terms greatly increase the amount of deductible interest that the estate must pay to the lender [normally to a related party] which, in turn, reduces the amount of the federal estate tax liability. In short, the IRS views these situations as deliberately creating estate illiquidity that forces the estate to borrow from a third-party lender who just happens to be a related party to the decedent, and thus  the loan and its ‘interest will not be actually and necessarily incurred in the administration of the decedent’s estate,’ which is a long-winded way of saying the that interest paid on the loan taken by the decedent’s estate will not be deductible when calculating the decedent estate’s federal estate tax liability.

Personal Guarantees Limited: The Proposed Regulations effectively create a baseline on the deductibility of amounts of interest paid on a personal guarantee given by the decedent. The guaranty must be bona fide and exchanged for adequate and full consideration in money and money’s worth. Restated, the decedent’s personal guarantee cannot be gratuitous. Thus, a father’s personal guarantee of his child’s home mortgage loan, where the guarantor is not paid for their personal guarantee, will not be a deductible claim by the deceased father’s estate. Moreover, the deductible amount of the outstanding personal guarantee will be reduced by the estate’s right of contribution or reimbursement from the borrower. In addition, if the decedent’s outstanding personal guarantee is with regard to an entity borrower over which the decedent had control [IRC 2071(b)(2)] then the amount of the deductible guarantee will be limited to the fair market value of the decedent’s interest in that ‘controlled’ entity.

Potential Impact on Regular Estate Planning Documents: The Preamble of the Proposed Regulations notes that if illiquidity has been created intentionally, whether in the estate planning or a body of the estate with knowledge or reason to know the estate tax liability, the interest expense incurred to address estate illiquidity will not be deductible. In short, more than just post-death steps to create illiquidity will be covered by these Proposed Regulations. Apparently the IRS will look at conventional estate planning steps taken during the decedent’s lifetime, many of which tend to produce illiquidity as a byproduct of their nontax purpose or reason. A couple of examples follow-

Buy-Sell Restrictive Agreements: A loan is taken by the decedent’s estate to pay federal estate taxes on the decedent’s closely held business interest, which is subject to a restrictive redemption agreement, with minimal payment terms for several years. This situation was intentionally created when the decedent, while alive. The  restrictive corporate buy-sell agreement is intended to prohibit the sale of stock outside of the decedent’s family- a bona fide buy-sell agreement that has a nontax reason/purpose that effectively causes the decedent’s estate to be illiquid as the stock is redeemed and paid over an extended period of time so as to not harm the family business. However, such a redemption agreement presumably would fall within the Regulation’s “with knowledge or reason to know the estate tax liability” prohibited condition.

ILIT: An irrevocable life insurance trust (ILIT) is often used to produce liquidity post-death in an otherwise illiquid estate. The ILIT is commonly employed as a source of liquidity outside the decedent’s taxable estate. Often the ILIT trustee will lend the life insurance proceeds to the estate’s Personal Representative to help fund the payment of federal estate taxes. Will the interest paid on that loan from the ILIT be deductible? Will there be limitations on the amount that might be deductible by the decedent’s estate, since the ILIT will be viewed by the IRS as a related party if its beneficiaries are the same as the beneficiaries of the decedent’s estate? Questions but not much guidance, sad to say.

Conclusion: The apparent focus of the Proposed Regulations with regard to IRC 2053 is to prevent perceived attempts by an estate to intentionally  produce illiquidity, which in turn forces the estate to obtain a loan from a related party, the interest on which is deductible against a 40% federal estate tax. As often seems to be the case, the IRS’s first attempt to create rules to address a perceived abuse instead causes overly broad rules and prohibitions that ignore common estate planning strategies that reflect non-tax reasons, but in practice also create bona fide illiquidity of an estate. Let’s hope that the IRS is provided several comments on why the proposed Regulations are overly broad in their sweep to prevent an intentional estate illiquidity, especially before 2026 arrives and  federal estate tax liability is back in the forefront of estate planning.