Proposed Regulations for Estate Tax Deductions

Take-Away: The Proposed Regulations with regard to the deductibility of debts and expenses of a decedent’s estate are precipitating some strong opposition due to their failure to take into consideration reality, especially when it comes to a family held business as a part of the decedent’s estate.

Background: As was previously reported, this past summer the IRS published Proposed Regulations to amend IRC 2053 that would affect the estate of decedents that seek to deduct funeral expenses, administration expenses, and/or claims against a decedent’s estate. [Notice 87, Federal Regulations 38331, June 28, 2022.] These Proposed Regulations also seek to provide, or clarify, rules under IRC 2053 with respect to the deductibility of interest expense that accrues on taxes and penalties owed by an estate, the deductibility of interest expense that accrues on certain loan obligations incurred by and estate, they added requirements to substantiate the value of a claim against a decedent’s estate that is deductible, and the deductibility of amounts paid under the decedent’s personal guarantee. The public was invited to provide comments to these Proposed Regulations. The American College of Trust and Estate Counsel (ACTEC) responded to that invitation with three comprehensive recommendations.

1. Interest Expense on Loan Obligations: The Proposed Regulations express an apparent concern over perceived abuses by estate to intentionally produce illiquidity that can then cause the estate to enter into loan agreement with related parties to intentionally generate interest estate tax deductions under IRC 2053. The Proposed Regulations provide that interest expense is deductible only if, among other things, the loan is actually and necessarily incurred in the administration of the decedent’s estate and is essential to the proper settlement of the decedent’s estate.

The Proposed Regulations go well beyond what is necessary to address this concern, and if adopted as proposed, they would penalize estate and other planning that is significantly motivated by non-tax considerations. Restated, there may be legitimate non-tax reasons to enter into a loan by an estate, with some ‘carve-outs’ from limitations on the deductibility of interest paid.

The Proposed Regulations directly address [eliminate?] the use of Graegin loans. [Estate of Graegin v. Commissioner, Tax Court Memo, 1988-477.]

The Proposed Regulations also address the perceived attempt by estates to produce illiquidity that is addressed through loan agreements with related parties that generate interest deductions. But the Proposed Regulations ignore fairly common, and legitimate, estate planning agreements, used especially in the context of family-owned and family-operated businesses, that include safeguards to preserve family ownership of the business, by limiting transfers of business interests outside the family, which often then results in the now-suspect illiquidity. Such illiquidity is genuine, and thus should not be a target of the Proposed Regulations.

2. Written Appraisal Documents: The Proposed Regulations state that for amounts deductible under IRC 2053, the expected date or dates of payment must be identified in a written appraisal document of a person who is qualified by knowledge and experience to appraise the claim being valued. That appraisal must be signed under penalties of perjury.

While the qualified appraisal rules used for charitable deductions would not apply to these Proposed Regulations with regard to debts and claims against a decedent’s estate, they would prohibit the appraisal being prepared by a related party, which makes it less likely that the person who signs the written appraisal document will have firsthand knowledge of the underlying facts.

There should be no requirement that a written appraisal document be signed under penalties of perjury.

Use of the word ‘appraisal’ itself is unnecessarily restrictive. Therefore, it should not be used unless only cited as an example of several options available to the estate tax return preparer.

Unlike the value of an unmarketable asset, a claim against the decedent’s estate will often be grounded mainly in legal arguments and considerations. An attorney who administers the decedent’s estate will be qualified to weigh such legal considerations and arguments and estimate the likely amount and timing of the payment of such claims against the decedent. Accordingly, the use of the word ‘appraisal’ should be dropped as it implies that it must be formally prepared by someone who is an ‘appraiser’ by profession. The use of a ‘statement’ in lieu of ‘appraisal’ is suggested.

3. Amounts Paid Pursuant to a Decedent’s Personal Guarantee: The Regulations provide that an estate may deduct under IRC 2053 claims against a decedent’s estate that are based upon the decedent’s agreement to guarantee a debt of another. The claim based on a personal guarantee of the decedent must: (i) represent a personal obligation of the decedent that exists at the time of the decedent’s death; (ii) be enforceable against the decedent’s estate; (iii) be a bona fide loan guarantee; and (iv) have been entered into in exchange for adequate and full consideration in money or money’s worth.

However, courts have regularly held that consideration need not be paid to the decedent to support the decedent’s loan guarantee. Rather, courts have held that a guarantor’s obligation is contracted for adequate and full consideration in money or money’s worth if there is a loan of money to a third party on account of a binding guaranty. The guarantor’s right to subrogation constitutes adequate and full consideration if the guarantor had a bona fide expectation of repayment.

Because of this common law interpretation, the Proposed Regulations should be clarified to state that while consideration is required for the underlying guaranty indebtedness, that consideration will be deemed to have been provided for the loan guarantee if a loan of money is made on account of the guarantee and the relevant facts and circumstances demonstrate a reasonable expectation of repayment.

Conclusion: There is absolutely no assurance that the IRS will seriously take ACTEC’s comments into consideration when it publishes the Final IRC 2053 Regulations. Hopefully, some common sense will prevail.