Proposed Changes to IRC Section 2053 Would Introduce Present Value Concepts for Estate Tax Deductions, Limit “Graegin Loans,” Complicate Deductions where Illiquidity Results from Estate Planning, and Limit the Deductibility of Guarantee Obligations in the Absence of Entity Control.

On June 28, 2022, the Internal Revenue Service published proposed regulations under Internal Revenue Code Section 2053 (the “proposed regulations”).[1]  The proposed regulations provide guidance on the use of present-value principles in determining the amount deductible by an estate for funeral expenses, administration expenses, and certain claims against the estate. In addition, the proposed regulations provide guidance on the deductibility of interest expense accruing on tax and penalties owed by an estate, and interest expense accruing on certain loan obligations incurred by an estate. The proposed regulations also amend and clarify the requirements for substantiating the value of a claim against an estate that is deductible in certain cases. Finally, the proposed regulations provide guidance on the deductibility of amounts paid under a decedent's personal guarantee. If adopted as final regulations in this form, the proposed regulations will affect estates of decedents dying on or after the date of publication of such final regulations. It is expected that the estate planning community will submit comments to address several concerning aspects of the proposed regulations.

Present Value Concepts Subject to a Three-Year “Grace Period”

Final Regulations issued in 2009 (the “2009 Final Regulations”) (74 FR 53652) reserved to provide future guidance on the application of present-value principles in determining the amount deductible under section 2053. According to the preamble to the proposed regulations (the “preamble”), the Treasury Department and the IRS (collectively, the “IRS”) has determined that limiting the amount deductible to the present value of the amounts paid after an extended 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 passing to the beneficiaries of the estate.  Accordingly, the IRS proposes to amend the regulations under section 2053 to incorporate present-value principles in determining the amount deductible for claims and expenses, subject to certain exceptions (including for unpaid principal of mortgages and certain other indebtedness).

Specifically, the rule in the proposed regulations requires calculating the present value of the amount of a deductible claim or expense that is not paid or to be paid on or before the third anniversary of the decedent's date of death, which three-year period the proposed regulations define as the “grace period.” The discount rate to be used is the applicable federal rate determined under section 1274(d) for the month in which the decedent's date of death occurs, compounded annually.

The proposed regulations require a supporting statement to be filed with the Form 706 estate tax return showing any calculations of present value. In addition, the proposed regulations provide that the expected date or dates of payment generally must be identified in a written appraisal document.

Interest Expense Accruing on Tax and Penalties Owed by an Estate

According to the preamble, the IRS has determined that interest payable on unpaid estate tax in connection with an extension under section 6161 or a deferral under section 6163 is necessarily incurred in the administration of the estate. In addition, the proposed regulations acknowledge that interest on estate tax installment payments that are authorized pursuant to section 6166 are not deductible for estate tax purposes—which is a point that seemed already clear, but presumably lent itself through its reiteration in connection with the proposed regulations’ coining of the term “non–section 6166 interest” to describe all other situations where interest can be payable in connection with the administration of an estate.

The proposed regulations take the view that when non–section 6166 interest has accrued on unpaid tax and penalties in connection with an underpayment of tax or deficiency and is attributable to an executor’s negligence, disregard of the rules or regulations, or fraud with intent to evade tax, the interest expense is not an expense actually and necessarily incurred in the administration of the estate. Accordingly, interest on taxes is not deductible to the extent the interest expense is attributable to an executor's negligence, disregard of applicable rules or regulations, or fraud with intent to evade tax.

Interest Expense Accruing on Certain Loan Obligations Incurred by an Estate

The proposed regulations take aim at the use of “Graegin Loans” (Estate of Graegin v. Commissioner, T.C. Memo. 1988-477) and perceived attempts by estates to “concoct” illiquidity to be addressed through loan agreements with related parties that prohibit the prepayment of principal and interest prior to the loan’s maturity date. Although the IRS’s concern is understandable, the prescription that the proposed regulations offer goes too far.

The preamble acknowledges that some estates face genuine liquidity issues that make it necessary to find a means to satisfy their liabilities, and incurring a loan obligation on which interest accrues may be the only or best way to obtain the necessary liquid funds. However, if illiquidity has been created intentionally—whether in the estate planning, or by the estate with knowledge or reason to know of the estate tax liability—prior to the creation of the loan obligation to pay estate expenses and liabilities, the underlying loan may be bona fide but (per the preamble) “most likely will not be found to be actually and necessarily incurred in the administration of the estate.”  (Preamble at 15; emphasis added)

The proposed regulations provide that interest expense is deductible only if, among other things, the loan's terms are actually and necessarily incurred in the administration of the decedent's estate and is essential to the proper settlement of the decedent's estate. Further, the proposed regulations provide a nonexclusive list of factors to consider in determining whether interest expense payable pursuant to such a loan obligation of an estate satisfies the applicable requirements. Among them is whether the loan obligation is entered into by the executor with a lender who is not a substantial beneficiary of the decedent's estate (or an entity controlled by such a beneficiary) at a time when there is no available alternative to obtain the necessary liquid funds to satisfy estate obligations. The preamble posits an example where either the need for the loan or any of the loan terms are contrived to generate, or increase the amount of, a deduction for the interest expense—in that case, the interest is not deductible. Further, if the loan obligation carried an extended loan term with a single balloon payment that does not correspond with the estate's ability to satisfy the loan, the preamble states that the interest accruing on the loan is not necessarily incurred in the administration of the estate (and therefore is not deductible).

The IRS appears to be extending its scrutiny not only to actions taken after death that may create illiquidity, but also to estate planning during the decedent’s lifetime that produces illiquidity post-death. This overlooks that there may be significant non-tax reasons for taxpayers to structure their holdings in ways that may not be liquid including to ensure that subsequent generations don’t sell their inherited business interests that the decedent has spent a lifetime building from scratch. An irrevocable life insurance trust (ILIT) is commonly employed to create a source of liquidity outside of the decedent’s taxable estate, with the trustee of the ILIT often lending the funds obtained through insurance proceeds to the executor to help fund the payment of estate taxes. The proposed regulations will need to be modified to expressly exonerate such pre-death funding arrangements (which can also be accomplished through business entities) from causing an estate’s interest deductions to be limited. 

Change in Requirements for Substantiating the Value of a Claim against an Estate

According to the preamble, the IRS has reconsidered the application of the “qualified appraiser” and “qualified appraisal” requirement in this context. The proposed regulations instead require a written appraisal that adequately reflects the current value of the claim when the Form 706 estate tax return is being completed. The current value of the claim should take into account post-death events occurring prior to the time a deduction is claimed as well as those events reasonably anticipated to occur. 

Deductibility of Amounts Paid under a Personal Guarantee

The proposed regulations provide that a claim founded upon a decedent's personal guarantee of another’s debt is a claim founded on a promise and, accordingly, must satisfy applicable requirements. Specifically, the guarantee must have been bona fide and in exchange for adequate and full consideration in money or money's worth (as opposed to gratuitous, even if enforceable under applicable state law). In addition, the proposed regulations provide that the estate's right of contribution or reimbursement will reduce the amount deductible.

The proposed regulations provide a bright-line rule that a decedent’s agreement to guarantee a bona fide debt of an entity in which the decedent had control [within the meaning of 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 also is satisfied if, at the time the guarantee is given, the maximum liability of the decedent under the guarantee did not exceed the fair market value of the decedent's interest in the entity. This creates a negative inference that the decedent’s personal guarantee in circumstances that fall outside these circumstances may not give rise to an estate tax deduction, even though the decedent may have had a substantial interest in the entity. This seems far too restrictive, and it is expected that comments to the proposed regulations will address this.

Kevin Matz, Esq., CPA, LLM, is a partner at the law firm of ArentFox Schiff LLP in New York City.  He earned his JD from Fordham University School of Law, New York, NY and his LL.M. in Taxation from New York University School of Law, New York, N.Y. He is a Fellow of the American College of Trust and Estate Counsel (ACTEC), where he chairs ACTEC’s Business Planning Committee and currently serves as co-chair of the Taxation Committee of the Trusts and Estates Law Section of the New York State Bar Association and as chair of the Estate and Gift Taxation Committee of the New York City Bar Association. He also currently serves as a Director on the NYSSCPA Board of Directors and as a Trustee on the FAE Board of Trustees, and chairs both the NYSSCPA’s Trust and Estate Administration Committee and the FAE Curriculum Committee. He may be contacted at (212) 745-9576 or kevin.matz@afslaw.com.