Service Targets Interest Deduction on Loans by FLPs
EXECUTIVE SUMMARY:
Keith Schiller, Schiller Law Group, a Professional Law Corporation, Orinda, CA, and member of the Leimberg Information Services Consulting Group, reviews the Service’s position regarding the administrative expense deduction under Code Section 2053 for interest on loans made by FLPs and family LLCs. In this review, Mr. Schiller cautions taxpayers of the tightrope that must be crossed to avoid Section 2036 implications while preserving some level of deduction. Mr. Schiller addressed this issue in depth in the course of the docketed Tax Court case, Estate of Hansen v. Comr. , but warns that the unique facts of that case may not be applicable in estates in which the borrowing is incurred to pay estate tax.
FACTS AND ISSUES:
Estates may face cash crunches for a variety of reasons… payment of taxes, beneficiary pressure for distributions, general administrative expenses, or the protection and preservation of assets. At times, these demands will be met through sales, other times from borrowing, or in the case of beneficiary pressure, the distribution of assets. Our focus is upon pressures other than distribution demands, and in particular, the payment of taxes and the use of borrowed funds to pay taxes.
When an estate must borrow, the most likely sources will be from the Internal Revenue Service (under one or more of the extension to pay sections, such as 6161, 6166 or 6163) or from a bank or third-party lender. Because interest expense is non-deductible for income tax purposes under Sec. 163(h) when the interest is incurred to pay taxes, it is crucial that the interest expense meets the deductibility rules under estate tax law.
Assume that an estate includes, among its assets, the ownership in a FLP or family LLC, and that either of these entities may be attractive sources for obtaining funds to pay taxes. Should assets be sold from these entities and distribution made? Should the estate borrow from such entities? In either event, what are the tax risks created from the sale or borrowing decision? Are risks heightened when the FLP or LLC is substantially a liquid asset/investment entity?
COMMENTS:
Treasury Regulation Sec. 20.2053-3 frames the criteria for administrative expense deductions, including interest, as follows:
“(a)ctually and necessarily, incurred in the administration of the decedent's estate; that is, in the collection of assets, payment of debts, and distribution of property to the persons entitled to it. The expenses contemplated in the law are such only as attend the settlement of an estate and the transfer of the property of the estate to individual beneficiaries or to a trustee, whether the trustee is the executor or some other person. Expenditures not essential to the proper settlement of the estate, but incurred for the individual benefit of the heirs, legatees, or devisees, may not be taken as deductions.”
When the Service is the creditor under a statutory deferral or extension rule, the fiduciary borrowing automatically is reasonable and necessary as an element of granting the extension or having satisfied the separate criteria for deferral under Code Sec. 6166. The 6166 deferral provides a reduced interest rate, which offsets the non-deductibility of the interest paid. When interest is paid under other extensions granted by the Service, the interest expense can be deducted for estate tax purposes when paid. The fiduciary should also file a protective refund claim (Form 843) to protect the interest deduction as an additional administrative expense for interest paid after the expiration of the three-year assessment period for estate tax.
Added Hurdle on Third-Party Borrowing
The regulatory test of “actual and necessary” for allowable purposes has been tested in a variety of cases. It is the mere fact that interest deduction has received such scrutiny when the lender was other than the IRS that should give the taxpayer pause to not take the interest expense deduction for granted.
For example, in Rupert (Knepp Estate) v. US , the Court denied the interest deduction because the estate could have sold the future payments under a lottery that was part of the gross estate and there was no evidence that the sale would have been a forced sale. The courts have been more willing to approve the third-party borrowing when the asset being preserved is a business, but as reflected in the cases cited, deductions have been denied when a business was not being protected or distressed sale was being avoided.
The decision in Graegin v. Comr . 56 TCM 387 (1988) is very important to taxpayers because it supports the current deduction (without present-value discount) of the future interest expense that will arise on a promissory note to which no prepayment is permissible. This result avoids the need to file supplemental returns or refund claims, and front-loads the deduction. In this case, the estate borrowed money to pay estate taxes on a 15-year promissory note from the business in which the estate was the principal shareholder. The business was active and a third party was also a shareholder. The Court noted as part of its reasoning that the existence of the third party would oversee the bona fides of the note. In other words, if the estate sought to prepay the interest, the outside shareholder could object to the corporation not protecting its long-term investment. Whether or not the third party’s existence was really germane or merely a point of added weight is not clear. The borrowing was needed to avoid a sale of the business.
Estate of Concordia v. Comr . provides that when the loan is determined to have been validly incurred under Section 2053, “(i)t makes no difference to whom it is owed.” Yet, to the IRS it does make a difference—at least when the lender is an investment FLP or LLC.
Another Assault on Investment LLCs and FLPs
Although not a public ruling, TAM 200513028 reflects the Service’s displeasure with borrowing from FLPs and LLCs, particularly when an identity of interest exists between the owners of the entity and the beneficial interests in the estate. The Service denied an interest deduction on a 10-year Graegin -type note in which the borrowing was from a FLP which held exclusively liquid assets and in which the decedent had been the owner of a 99% interest. The Service reasoned that the estate could have pierced through and obtained the liquid assets underlying the entity. The Service also reasoned that the payments would have no economic impact on the parties because the owners were the same (i.e., no other owner as in the Graegin decision). In so doing, the Service disregarded the entity, itself as a business and, indirectly, worthy of recognition.
The antagonism toward borrowing from an in-house estate planning entity was not shared Estate of Thompson v. Comr. T.C. Memo. 1998-325, in which the Tax Court approved an interest deduction when the funds were needed to protect a real estate investment in which the estate had an interest. The holding of the case addresses the issue of whether or not a state court order was required. However, in the facts of the case, the borrowing was from an ILIT. The author of this article spoke to Robert H. Hishon, counsel for the taxpayer in the Thompson case, who recalled that the beneficiaries of the Irrevocable Life Insurance Trust were the same as those of the decedent’s estate.
The Thompson case considered both the tax liability and the needs to protect the real estate investment. At paragraph 53, the court states:
“We are convinced that the financial position of the estate at the time of the borrowing was insufficient to make the required tax payments and provide for the maintenance of Cane Mill until such time as the asset could be distributed to decedent's heirs. cf. Estate of Street v. Comr , T.C. Memo. 1994-568. In that connection, William O. Dorough, Jr., a senior vice president of Synovus and the individual responsible for the administration of decedent's estate from the date of decedent's death, testified credibly that a shortfall of approximately $600,000 existed between estate tax liabilities and liquid assets (the publicly traded stocks) available to pay them.”
The Service’s disapproval of borrowing from the family LLC or FLP inherently undermines the business purpose for validly formed entities. While loans from operating businesses or to preserve real estate are permitted, the preservation of the investment base of a LLC/FLP is considered unjustified by the IRS, at least when the entity is predominantly liquid and, perhaps, when the ownership in the entity and beneficial interest in the trust are the same or similar. The Service does not, by this position, respect the legitimate desire of the entity to protect its asset base by allowing the entity to make a loan and deduct the interest for estate tax purposes. The Service, in essence, disregards the LLC or FLP by piercing through the entity to its underlying assets, and to those assets apply the traditional analysis of liquidity and availability of cash to pay estate tax rather than borrow.
Beware of the Section 2036 Conundrum
To make matters worse, the distribution of assets by the family LLC or FLP in lieu of borrowing to raise money for estate necessities will make matters worse under Code Section 2036.
The Fifth Circuit’s opinion affirming estate tax inclusion of the underlying assets in the FLP in Strangi v. Comr. (“ Strangi II ”) provides a significant warning to fiduciaries and owners of family LLCs and FLPs who are contemplating distributions from the entity to the members to provide funds to pay estate tax or other obligations of the decedent’s estate.
If the FLP makes a distribution to assist the estate’s ability to meet its obligations, the IRS will argue inclusion under Sec. 2036(a)(1). In Strangi II , the taxpayer argued that only pre-death distributions could be considered on the issue of testamentary substitute, while the Service argued that the post-death distributions could be considered as well as indicative of the testamentary plan. As indicated in footnote #5 to the Strangi II opinion and the accompanying discussion, the Court concluded that the post-death distributions could be considered in the 2036 analysis. The opinion states, "Certainly, part of the 'possession or enjoyment' of one's assets is the assurance that they will be available to pay various debts and expenses upon one's death." The Fifth Circuit referenced Estate of Ray v. US in the process.
TAM 200513028 does not discuss the Section 2036 issue.
IRS Seeks FLP Loans to Challenge Interest Deduction
From the author’s discussion with IRS appeals, the Service is looking for cases to determine this issue and is opposing deductions from liquid FLPs and LLCs, particularly when outsiders have no interest in the entity.
This opposition exists, notwithstanding the concurrent argument that in the event the family entity sells assets and makes post-death distributions to avail the estate of funds to pay taxes and administration expenses that such post-death distributions are an indicator of testamentary purpose to rope in the decedent’s interest in the underlying assets of the FLP or LLC. The apparent inconsistency of the Service’s position – the taxpayer losses with heads or tails—does not bother the Service, given its displeasure with liquid FLPs and LLCs in the first place.
Consider Borrowing From a Commercial Lender
In the event of these considerations, the fiduciary may prefer to borrow money from a commercial lender rather than involving the investment LLC or FLP in the matter. In PLR 200020011, the Service allowed an interest deduction as an administrative expense when the executor borrowed money from a commercial lender without right of prepayment. TAM 200513028 addresses FLP/LLC borrowing from a liquid entity. Commercial lending avoids the immediate hurdle.
It remains to be seen whether or not the Service argues in a given case the FLP or LLC assets should be sold in any event. Presumably, if the entity passes muster under Section 2036, its separateness from the estate should be respected as well.
Substantiate Borrowing Purposes Other than Estate Tax Payments
The all-or-nothing quality of the interest deduction when borrowing is incurred to pay taxes can be softened if legitimate administration expense pressures exist from other causes. For example, if the estate must borrow money to protect its investments, repair property, maintain property until it can be distributed, or fund the estate’s interests in litigation, the interest expense should be deductible for income tax purposes if the deduction is denied under IRC Section 2053.
In this respect, the income tax deduction for interest could be classified as investment interest and avoid the taint of money borrowed to pay taxes.
From the estate tax standpoint, expenses incurred to ensure the value of property are allowable administration expense deductions. For example, in Estate of Papson v. Comr. , the court approved a deduction for a broker’s commission incurred to obtain a new shopping center tenant on the rationale of preservation of value.
Experience of the Estate of Hansen
The issues presented in this article were addressed recently by the author, as Petitioner’s counsel, in the Hansen Estate v. Comr., Tax Court Docket No. 016607-4.
During the administration of the decedent’s trust estate, it was necessary for the trustee to commence litigation against two of the decedent’s sons who managed a steel fabrication corporation that leased its equipment and machinery from a general partnership controlled by the sons. The corporation had no lease, its rights to the equipment and machinery could be terminated by the partnership on 30-days’ notice, and the partnership had a claim for back rent in excess of $2 million. The decedent’s trustee filed a civil action to protect the trust estate’s interest in the corporation and avoid the value being dissipated through lease claims. The civil litigation reached the California Court of Appeals with greater than $1.4 million in legal fees being insured by the living trust (and another $2.1 million by the corporation).
The trustee borrowed roughly $1.5 million from a liquid FLP on a Graegin -type note (i.e., no right of prepayment). As an aside, the Service agreed that no Section 2036(a)(1) inclusion existed. This decision to not pursue the Section 2036(a)(1) argument is significant because the estate tax examiner is well known in California, and is the same examiner who handled the audits in the Service’s successful 2036 positions in Estate of Harper v. Comr . and Estate of Hillgren v. Comr . However, the Service did assert Section 2036(a)(2) inclusion, which argument it abandoned in appeal after the case was docketed and shortly prior to trial.
The Service agreed on appeal that the litigation expenses were reasonable and necessary deductions under Section 2053. The Service would not reconsider its position from asserting no interest expense deduction for estate tax purposes under Code Section 2053. However, under the facts of this case and given the importance of the borrowing to protect the estate’s investment in the corporation and partnership, the Service stipulated that the interest expense was a proper income tax deduction.
As a point of caution, practitioners should not automatically expect to receive an income tax deduction as a result of the denial of the estate tax deduction on audit or appeal. The facts of each case will be considered on its own merit.
Conclusion
The Service’s scrutiny of family LLCs and FLPs extends beyond the gross estate and includes administrative expense deductions, particularly with liquid entities owned only by the estate beneficiaries. While it may be tempting to make distributions to satisfy administration needs, beware of invoking a Section 2036 argument. When borrowing is preferred choose the creditor wisely, beware of the purpose for the loan and the Service’s desire to expand its challenges to liquid investment family entities, and when possible leave a back door to protect a possible income tax deduction.
CITES:
Graegin v. Comr. 56 TCM 387 (1988); Estate of Papson v. Comr. 73 T.C. 290 (1979); Estate of Concordia v. Comr. TC Memo 2002-2; Redlark v. Comr . 98 AFTR2d Par. 98-606 (9 th Cir.) rev’g 106 T.C. 2 (1996); Miller v. U.S ., 65 F.3d 687 (8th Cir. 1995); See , Hibernia Bank v. U.S. 581 F.2d 741 (9th Cir. 1978), aff'g 75‑2 USTC ¶13,102 (N.D. Calif. 1975) and Rev. Rul. 79-252, 1979-2 C.B. 333; Estate of Bailly v. Comr . 81 TC 949; Estate of Mary Wetherington v. Comr . 108 TC 49 (1997); Pickett v. U.S . 90-2 USTC ¶ 60,030(D.Fl. 1990); Axtell v. U.S. 860 F. Supp (D.Wyo. 1994); Rupert (Knepp Estate) v. US 2004-2 USTC Par. 60492 (DC Penn.); Estate of Gilman v. Comr . TC Memo. 2004-286; Estate of Todd v. Comr . 57 TC 288 (1971); Estate of Thompson v. Comr . TC Memo 1998-235; McKee v. Comr . TC Memo. 1996-362; Estate of Ray v. US 762 F. 2d 1361,1363 (9 th Cir. 1985); in Estate of Harper v. Comr . TC Memo 2000-202, TC Memo 2002-121; and Estate of Hillgren v. Comr . TC Memo. 2004-46.
