This reflects Shenkman final revisions in track change 11/4/22.

Table of Contents

• Executive Summary.
• The Proposed Regulations.
  • Present Value Concepts
  • The Three-Year Grace Period.
  • Calculations.
  • Filing a Protective Claim for a Contingent Obligation.
  • Deductibility of Amounts Paid Under Personal Guarantees.
  • Substantiation Requirements for Valuations of a Claim Against an Estate.
  • Graegin Loans.
  • Interest On Certain Loan Obligations Incurred by an Estate.
  • Interest on Tax and Penalties Owed.
• Conclusion.

Executive Summary.

On June 28, 2022, the IRS published Proposed Regulations pursuant to Internal Revenue Code Section 2053.[1]^,[2]

Proposed regulations can be relied upon by taxpayers, but do not have to be followed. The IRS is required to review the comments that had been made by taxpayers and various organizations. The deadline for comments ran on ______. It is expected that the IRS will issue slightly different final regulations in the next few weeks or months [What’s the timing?]

If the Proposed Regulations are enacted, they will make probate administration and completion of federal estate tax returns for some estates more complex, more costly to address, and more costly to the estate in terms of non-deductible interest charges. Some deductions will be reduced, and other will be eliminated entirely. Appraisals will now be required for debts that previously did not require appraisals. In some instances, return preparers may have to obtain, or may merely choose to obtain, third party analysis of certain deductions.  In 2026 when the exemption is reduced by half, more estates will be subject to estate tax and the new rules will have an impact on a larger number of estates.

Under Internal Revenue Code Section 2053, certain liabilities and expenses that are paid or incurred to satisfy the obligations of a deceased person’s estate may be deductible for federal estate tax purposes. The IRS proposed regulations in 2009 that would have required certain liabilities and expenses to be discounted to take into account the time value of money when they were to be paid well after the death of a decedent.  The Final Regulations published in 2009 set forth the use of post-death events in determining deductible amounts for expenses and claims against the estate, and dropped the present value concepts; however, the IRS stated that they would continue to assess the use of present value concepts for future regulations.[3] The proposed regulations issued this summer complete the 2009 revisions by adding present value concepts for items paid after a three-year grace period.

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. These rules can be harsh and, in some instances, create increased risk to tax preparers that will require precautionary steps.

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. These will result in return preparers considering obtaining third party appraisals and analysis in instances where under current law the preparer would have completed any calculations or evaluation on their own.  This will add increased cost and complexity to the estate tax return preparation process. Finally, the Proposed Regulations provide guidance on the deductibility of amounts paid under a decedent’s personal guarantee.

Section 2053 Basics

Section 2053 generally allows for an estate to deduct certain expenses, claims and debts of the decedent from the value of the gross estate in determining the value of the net taxable estate.  These include: (1) funeral expenses, (2) administration expenses, (3) claims against the estate, and (4) unpaid mortgages where the value of the property subject to such mortgage is included in the gross estate.

Deductions under Section 2053 for the items listed above are limited to: (1) the value of property included in the gross estate that is subject to claims, plus (2) amounts paid out of property not subject to claims that is paid prior to the due date of the Estate Tax Return.

A deduction is also allowed for expenses incurred in administering property that is not subject to claims but that is includible in the gross estate if such expenses are “occasioned by the decedent’s death and incurred in settling the decedent’s interest in the property or vesting good title to the property in the beneficiaries.”  In order to be deductible without discount, all expenses under this category must be paid prior to the end of the three year limitation for assessments period.

Regulations issued in 2009 required that in order for an expense or claim to be deductible it must be bona fide in nature, and that no deduction would be permissible to the extent “it is founded on a transfer that is essentially donative in character (a mere cloak for a gift or bequest).”

Existing Treasury Regulations also allow a deduction for unpaid amounts that are ascertainable with reasonable certainty and will in fact be paid. The claim or expense must not be contingent or contested, or based on a vague or uncertain estimate in order to be deductible prior to payment. If the uncertainty extends beyond the time period for filing a claim for refund, then the estate may file a protective claim for refund to preserve the estate’s right to claim a refund when the claim or expense is actually paid, or becomes ascertainable with reasonable certainty.

Often times administrative and other expenses are not paid until the last tax year of an estate because excess deductions can be allocated to the individual beneficiaries. Now, waiting until after the third year to pay certain obligations will cause the value of such obligations to be reduced.

The Proposed Regulations.

Present Value Concepts

The Preamble to the Proposed Regulations states 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, and the true economic cost of that expense or claim. Accordingly, the Proposed Regulations incorporate present-value principles in determining the amount deductible for claims and expenses, subject to certain exceptions (including exceptions for owed on mortgages and certain other indebtedness). It is unclear whether the exception for mortgages may provide a planning opportunity to mitigate against any of the new harsher rules.

The Three-Year Grace Period.

The Proposed Regulations provide a simplifying approach to present valuing certain debts by exempting relatively short estate administration expenses. This is accomplished by introducing a general three-year safe harbor before any present value discounting will be required.  This should effectively exempt most simple estates from the complications proposed, as presumably such estates would make all payments within the three-year grace period.

The three-year period “takes into account a reasonable time for administering and closing the estate,” while not being an overly long period of time such that the lack of present value discounting would significantly distort the value of the net (distributable) estate. Thus, applying present-value principles in computing the deductible amount of those claims and expenses paid more than three years after the decedent’s death “strikes an appropriate balance between benefits and burdens.” As a result of the three year grace period the interest rates that apply will therefore be the federal mid-term rate applies to loans that a term of more than three years and no more than nine years. The long-term applicable federal rate applies to loan having a term exceeding nine years, since only contingencies three years or later past the date of death are to be discounted.

Thus, a liability or expense that is paid more than three years after the anniversary date of the decedent’s date of death would be discounted under the Proposed Regulations by the applicable federal rate that applies to the month in which the decedent’s death occurs, compounded annually.

Calculations.

The discount rate to be used is the applicable federal rate determined under IRC Section 1274(d) for the month in which the decedent’s date of death occurs, compounded annually. It may be of interest that the rate to be used in determining the minimum interest to be charged on a promissory note between related parties is the applicable federal rate, compounded semi-annually. [foot note this]

The payments are to be discounted from the “expected date.”  The expected date “must be determined using all information reasonably available to the taxpayer to make a fair and reasonable estimate of the expected date or dates of payment” which must be identified in a qualified written appraisal.[4] Qualified written appraisal is defined as ______ – Can we define it?

The Proposed Regulations would apply the present-value principles to expenses and claims without regard to whether they are contingent.  However, one exception to the present value discounting is provided for unpaid mortgage principal or other indebtedness deductible under Treas. Reg. §20.2053-7, which reads as follows: [Do we want to quote the language?]

The midterm applicable federal rate would be used if the liability or expense is expected to be paid more than three years after the death of the decedent but within nine years, and the long term applicable federal rate will apply if the liability or expense is expected to be paid more than nine years after the date of death. The short term applicable federal rate cannot apply because it would be within the three year grace period when discounting is not required.

The Proposed Regulations indicate that “reasonable assumptions and methodology can be used” to calculate the present value of the post-grace period payment(s). The proposed revisions and addition to Section 20.2053-4 would read as follows:

The value of each such claim against the estate is supported by a written appraisal document to be filed with the Form 706, or successor form, and the written appraisal document—

            (A) Adequately reflects post-death events that have occurred prior to the date on which a deduction is claimed on an estate’s Form 706;

            (B) Reports, considers, and appropriately weighs all relevant facts and elements of value as are known or are reasonably determinable at the time of the appraisal, including the underlying facts of the claim against the estate, potential litigating risks, and the current status of the claim and procedural history;

            (C) Takes into account post-death events reasonably anticipated to occur;

            (D) Identifies an expected date or dates of payment (for purposes of determining the applicability of the present value limitation in § 20.2053-1(d)(6));

            (E) Explains in detail the methods and analysis that support the appraisal’s conclusions;

Thus, it appears that rather than mandating a specific formula the Proposed Regulations permit any reasonable approach to the analysis. “Any reasonable assumptions and methodology in regard to time period measurements may be used to calculate, in accordance with paragraph (d)(6)(ii) of this section, the present value of the post-grace-period payment(s).” Practitioners may consider the benefits of having an appraiser perform the analysis in the event that they may be able to justify a more favorable approach than what the practitioner may calculate.

The import of the above is that estate tax return preparation will have to change. If the return preparer is a law firm, will an attorney be deemed to have the requisite expertise to complete the above analysis of a claim? Does an attorney have the training to “appropriately weigh” the factors indicated above? Some will, some may not. If that is even questionable, might it be preferable for counsel preparing a Form 706 to hire an outside expert to address the above issues?

The reasonable assumptions or methodology consider: (a) a facts and circumstances analysis, or (b) the use of actuarial tables. Fair market value generally involves estimates and both of these methods of valuation require the knowledge of the facts. With respect to valuation of gifts or assets included in the decedent’s gross estate, courts routinely determine fair market value by looking at transactions occurring after the decedent’s date of death, as long as these facts were reasonably foreseeable. To value a deduction under Treasury Regulation Section 2053, relevant post-death facts will have to be considered when interpreting the claim’s date-of-death value.

The above process may add potentially significant cost and complexity to the administration of estates with claims to be valued under the Proposed Regulations.

The Proposed Regulations provide guidance on calculating the present value of amounts paid or payable, with respect to the grace period in Section 20.2053-1(d)(6):

(A) Single post-grace-period payment. The amount deductible under section 2053 for a single post-grace-period payment is computed by calculating the present value of such payment as follows:

Amount of future payment × [1 ÷ (1 + i)]^t

Where:

            t  is the amount of time (expressed in years and fractions of years) from the day after the decedent’s date of death to the payment date or expected date of payment; and

            i  is the applicable discount rate.

(B) Multiple post-grace-period payments. The amount deductible under section 2053 for multiple post-grace-period payments is computed by calculating the present value of each such payment using the formula in [paragraph (A)] of this section; the sum of the discounted amounts of the post-grace-period payments is the amount that is deductible for such payments.

The calculations should not be that difficult mechanically to make in many instances, and practitioners will need to become familiar with using the above formula or present value calculations in Microsoft Excel or similar software. They will be more complex if there are varying payments over many separate years as each payment will need to be separately discounted and aggregated to compute the final deductible amount. Also, once the Regulations are finalized it is likely that the software companies that practitioners commonly used to make an array of estate planning calculations will add to their offerings software to make the calculations required under the then new Regulations. Even with those offerings return preparers will need to consider whether it would be preferable to have a third-party expert, e.g., a valuation firm, provide a report with the calculations.

Example: A simple example to illustrate the present value calculation is as follows.

Decedent has a debt of $100,000 due in four years, she will pay it as a lump sum, and the applicable interest rate when Decedent dies is 4%.

The calculation is as follows: $100,000 × [1 ÷ (1+0.04)⁴] = $85,480.42. Therefore, under the Proposed Regulations, Decedent or her estate must pay the $100,000 debt in full four years from now, but she may only deduct $85,480.42 from the estate under the present value calculation.

The calculations may be more complex if the debtor is required to make annual or monthly payments, rather than the lump sum from the example given.

To clarify, payments under the obligation made during the three-year grace period do not need to be discounted. This would also include payments which are part of a stream of payments that exceed the grace period. So, if the particular obligation requires payment each year for 12 years, the payments made within the first three years of the date of death are not discounted but the remaining nine payments would be discounted.

Example: This is based on the Example 4 in the Proposed Regulations:

Example 4: Discounting amount paid more than three years after decedent’s date of death.…E files a timely protective claim for refund in accordance with paragraph (d)(5) of this section to preserve the estate’s right to claim a refund, a final judgment in the amount of $100x is entered against and paid by the estate precisely five years after D’s date of death, and the applicable Federal (mid-term) rate determined under section 1274(d) for the month in which D’s date of death occurs, compounded annually, is 2.00%. Within a reasonable period of time after the final judgment is entered, E notifies the Commissioner that the contingency has been resolved. E may claim a deduction for the present value of the amount paid in satisfaction of the claim as of D’s date of death. Under the facts in this paragraph (d)(7)(iv), the present value of the amount paid in five years equals $100x / (1 + .0200)5 or $100x/1.104081 or $90.57x.”

The above example illustrates how the calculation is made. Also, the example illustrates how the claim is not made on the original return because of an outstanding contingency, but rather after the contingency is resolved, the executor must notify the IRS and files an amended return. This requires that a claim was preserved on the initial filed estate tax return.  This is discussed in the section below.

Example: This is based on Example 6 in the Proposed Regulations:

Example 6: Discounting amount to be paid for series of payments payable over a period that does not end on or before the third anniversary of the decedent’s death. Pursuant to the terms of a divorce and separation agreement entered on June 1 of Year 1, Decedent (D) is obligated to make annual payments of $100x to Claimant (C) on September 1 of year 1 and each September 1st thereafter until D has made a total of 10 such payments. D dies on December 1 of Year 5 after having made the first five annual payments required under the agreement. The applicable Federal (mid-term) rate determined under section 1274(d) for the month in which D’s death occurs, compounded annually, is 2.00%. The executor of D’s estate (E) may claim a deduction with respect to C’s claim on D’s Form 706 under the special rule contained in paragraph (d)(4) of this section because the deductible amount can be ascertained with reasonable certainty. E computes the discounted deductible amount of the claim by adding the undiscounted amount of the three payments that will be made before the third anniversary of D’s death ($300x) to the discounted amounts of the two payments that will be made after the third anniversary of D’s death. Accordingly, the amount deductible for the claim equals $483.866x ($300x + $92.843x + $91.023x). The individual calculations for the present values of the payments in the last two years of the payment obligation are shown in table 1 to this paragraph (d)(7)(vi).”

This example illustrates the interplay of the 3-year grace period when there is a multi-year payment. The example, however, does not address the possible contingency that the payments to the ex-spouse may cease on the death of the ex-spouse. If that were to be the case, and the matrimonial settlement agreements would have to be reviewed to identify whether it would, then an actuarial analysis may be necessary if the amount is to be deducted on the return and a determination would have to be made as to how to report the cessation of the payments due to the death of the ex-spouse. The Proposed Regulations do not appear to address this situation.

Filing a Protective Claim for a Contingent Obligation.

The Proposed Regulations do not address nor change the requirements that a protective claim for a contingent liability needs to be filed with the estate tax return. Practitioners, however, need to be mindful of this requirement as if the protective claim for refund is not appropriately filed, the ability to apply the present value requirements under the Proposed Regulations to claim a later deduction will be lost. The following provides a brief overview.

The instructions to Form 706 provide the following guidance on filing a protective claim. On the initially filed Form 706, file Schedule PC (protective claim) to make a protective claim for refund for expenses which are not currently deductible under section 2053. For such a claim, report the expense on Schedule J but without a value in the last column. A protective claim for refund preserves the estate’s right to a refund of tax paid on any amount included in the gross estate which would be deductible under section 2053 but has not been paid or otherwise will not meet the requirements of section 2053 until after the limitations period for filing the claim has passed.[5]

Schedule PC is to be used only for section 2053 protective claims for refund being filed with Form 706. If the initial notice of the protective claim for refund is being submitted after Form 706 has been filed, use Form 843, Claim for Refund and Request for Abatement, to file the claim.

Schedule PC may be used to inform the IRS when the contingency leading to the protective claim for refund is resolved and the refund due the estate is finalized. The estate must indicate whether the Schedule PC being filed is the initial notice of protective claim for refund, notice of partial claim for refund, or notice of the final resolution of the claim for refund. Because each separate claim or expense requires a separate Schedule PC, more than one Schedule PC may be included with Form 706, if applicable.

Filing a section 2053 protective claim for refund on Schedule PC will not suspend the IRS’s review and examination of Form 706, nor will it delay the issuance of a closing letter for the estate.

The first Schedule PC to be filed is the initial notice of protective claim for refund. The estate will receive a written acknowledgment of receipt of the claim from the IRS. If the acknowledgment is not received within 180 days of filing the protective claim for refund on

Schedule PC, the fiduciary should contact the IRS at 866-699-4083 to inquire about the receipt and processing of the claim. A certified mail receipt or other evidence of delivery is not sufficient to confirm receipt and processing of the protective claim for refund. It is important that this requirement to follow up not be overlooked.

For a protective claim for refund to be properly filed and considered, the claim or expense forming the basis of the potential section 2053 deduction must be clearly identified. The following instructions will apply:

1. List any amounts claimed under exceptions for ascertainable amounts (Regulations section 20.2053-1(d)(4)), claims and counterclaims in related matters (Regulations section 20.2053-4(b)), or claims under $500,000 (Regulations section 20.2053-4(c)).
2. Provide all relevant information as described, including, most importantly, an explanation of the reasons and contingencies delaying the actual payment to be made in satisfaction of the claim or expense.
3. Show the amount of ancillary or related expenses to be included in the claim for refund and indicate whether this amount is estimated, agreed upon, or has been paid.
4. Also, show the amount being claimed for refund.

Deductibility of Amounts Paid Under Personal Guarantees.

The Proposed Regulations also provide that any claims that are based upon a promise to pay by the decedent will be deductible only if (1) the promise represents a personal obligation of the decedent existing at the time of the decedent’s death, and (2) the claim is legally enforceable against the decedent’s estate.

The Proposed Regulations indicate that a deduction for a claim founded upon a promise or agreement is limited to the extent that the promise or agreement “was bona fide and in exchange for adequate and full consideration in money or money’s worth. That is that the promise or agreement must have been bargained for at arm’s length and the price must have been an adequate or full equivalent reducible to money value.” This would appear to eliminate a deduction for an unsatisfied non-binding promise gift that has become common in recent years in an attempt to use up the temporary increased estate tax exemption amount.

The IRS recently issued Proposed Regulations on the anti-clawback rules that confirmed that the IRS would not “clawback” a decedent’s exemption that was used during his or her lifetime if the exemption was a lower amount upon death. [To be discussed- Alan wants to read these regulations.]

However the recently Proposed Clawback Regulations which are separate and apart from the Section 2053 proposed regulations provide certain exceptions to the anti-clawback rules which are intended to target what the IRS has referred to as “artificial” use of the exemption, specifically stating:

• 20.2010-1(C)(3) Exception to the special rule—(i) Transfers to which the special rule does not apply. Except as provided in paragraph (c)(3)(ii) of this section, the special rule of paragraph (c) of this section does not apply to transfers includible in the gross estate, or treated as includible in the gross estate for purposes of section 2001(b), including without limitation the following transfers:…(B) Transfers made by enforceable promise to the extent they remain unsatisfied as of the date of death…

Under the clawback proposed regulations, a gift that is a promise to make a payment that is actually satisfied more than 18 months prior to the decedent’s death will be respected, and will not be “clawed back”. However, if the promise gift remains unsatisfied at the time of the decedent’s death, then the it will not be considered has having been made at the time of the promise, the assets will be included in the decedent’s estate, and the exemption available at the time of the decedent’s death will apply. In other word’s any bonus exemption the promise to give purported to have used will be recaptured if the Proposed Clawback Regulations are finalized in the present form.  Further, due to the donative nature of the promise to give, the debt will not be bona fide and thus not deductible under Section 2053.

This may be viewed by some as unfair because under some state’s laws a promise to pay will be enforceable even when the consideration received by the promisor is gratuitous or nominal. But the combination of loss of bonus exemption supposedly secured by the promise and the ability to even deduct the promise, except for the limited exception above if paid before death, appears to so weaken that technique that practitioners should review any existing promise gifts, and evaluate carefully whether that technique should be utilized even if state law permits it.

The Proposed Regulations also discuss the decedent’s promise to guarantee a debt, and provide that such guarantee will only be deductible if it is “bona fide and in exchange for adequate and full consideration.”  Fortunately the Proposed Regulations do provide a safe harbor that will apply, if the guarantee relates to an entity that the decedent had an ownership interest in, and provide that the bona fide and adequate and full consideration will be satisfied if at the time that the guarantee was given the decedent had control of the entity, as defined in IRC Section 2701(b)(2) or to the extent that the maximum liability of the decedent under the guarantee did not exceed the fair market value of the decedent’s interest in the entity at the time the guarantee was given.

Example: The Proposed Regulations provide the following example:

Example 10: Guarantee. On Date 1, D entered into a guarantee agreement with Bank (C) to secure financing for a closely-held business (LLC) in which D had a controlling interest. LLC was solvent at the time LLC executed a promissory note in the amount of $100x in favor of C. Prior to D’s death, LLC became insolvent and stopped making payments on the note. After D’s death, C filed a claim against D’s estate for payment of the remaining balance due under the note and E paid the full amount due. Although E had a right of contribution against LLC for primary payment of the indebtedness, LLC was insolvent and no part of the debt was collectible at the time E deducted the payment. D’s estate may deduct the amount paid to C in satisfaction of D’s liability under the guarantee agreement. The guarantee agreement is considered to have been contracted for an adequate and full consideration in money or money’s worth. The result would be the same if D did not have control of LLC as long as the fair market value of D’s interest in the LLC on Date 1 was at least $100x.

An estate’s right of contribution or reimbursement will reduce the amount deductible in a guarantee situation. Payments made to actually satisfy the guarantee after the death of the decedent will be deductible “only to the extent that the debt for which the guarantee is given has not been taken into account in computing the value of the gross estate” under Section 20.2053-7 or otherwise.

The above limitations are significant and, in many situations, may prevent deduction for guarantees. Practitioners will have to evaluate the control or valuation tests before claiming a deduction.

Substantiation Requirements for Valuations of a Claim Against an Estate.

Proposed Treasury Regulation Sections 20.2053-4(b)[6] and (c)[7] provides exceptions to the general rule that an estate may deduct only amounts that actually are paid by the estate in satisfaction of a claim.

Proposed Treasury Regulation Section 20.2053-4(b) generally allows a deduction for the value of claims against the estate that are related to assets or claims included in the gross estate, and Section 20.2053-4(c) allows a deduction for the value of unpaid claims totaling not more than $500,000. In each case, certain requirements must be satisfied to enable the estate to deduct the claim including:

1. Each claim against the estate otherwise satisfies the requirements for deductibility under Section 2053.
2. Each claim against the estate represents a personal obligation of the decedent that exists at the time of the decedent’s death.
3. Each claim is enforceable against the decedent’s estate (and is not unenforceable when paid).
4. The value of each claim against the estate is subject to adjustment for post-death events.
5. The aggregate value of the related claims or assets included in the decedent’s gross estate exceeds 10 percent of the decedent’s gross estate for deductions under 20.2053-4(b), and does not exceed $500,000 in total for claims deducted under Section 20.2053-4(c). It is noteworthy that the Proposed Regulations provide that the $500,000 limitation is applied after the new present value reductions.
6. Appraisal requirement.

Under current Regulations the value of a claim against the estate that is deductible under Section 20.2053-4(b) or (c) must be determined by a “qualified appraisal” performed by a “qualified appraiser” based upon the definitions that apply in the charitable income tax rules under IRC Section 170.

The Treasury Department and the IRS have determined that the rule in Section 20.2053-4(b) and (c) should remove the “qualified appraisal” performed by a “qualified appraiser” requirement; instead, the Proposed Regulations instead would require that the value of each claim against the estate be supported by a written appraisal document to be filed with the Form 706 and specifies that the written appraisal document should:

1. Adequately reflects post-death events that have occurred prior to the date on which a deduction is claimed on an estate’s Form 706.
2. Report, consider, and appropriately weigh all relevant facts and elements of value as are known or are reasonably determinable at the time of the appraisal, including the underlying facts of the claim against the estate, potential litigating risks, and the current status of the claim and procedural history.
3. Take into account post-death events reasonably anticipated to occur.
4. Identify an expected date or dates of payment (for purposes of determining the applicability of the new present value limitations.
5. Explain in detail the methods and analysis that support the appraisal’s conclusions.
6. Be prepared, signed under penalties of perjury, and dated by a person who is qualified by knowledge and experience to appraise the claim being valued and is not a family member of the decedent, a related entity, or a beneficiary of the decedent’s estate or revocable trust (as those terms are defined in §20.2053-1(b)(2)(iii)), a family member of a beneficiary or a related entity as to a beneficiary (as those terms would be defined in §20.2053-1(b)(2)(iii) if references therein to the decedent were replaced with a reference to such beneficiary, and without regard to the limitations in §20.2053-1(b)(2)(iii) based on the decedent’s date of death), or an employee or other owner of any of them;
7. Include a statement providing the basis for the person’s qualifications to appraise the claim being valued.

These requirements could add substantially to the cost and time required to complete a return. Further, practitioners will have to evaluate whether or not they wish to prepare these estimates or retain outside appraisers to do so, potentially adding further to the costs.

Graegin Loans.

The Proposed Regulations also take aim at “Graegin loans,” which are loans taken out by an estate for the purpose to pay administration expenses and may be used to prevent unwanted liquidation of estate assets to pay estate taxes and other expenses. In Graegin, the estate successfully deducted all of the interest due on a long-term estate loan as an administration expense under Section 2053 on its estate tax return.[8]

The Graegin loan technique has been used by many estates to provide a mechanism to fund some or all of the estate tax payment for an illiquid estate, while simultaneously reducing the value of the taxable estate by the amount of interest to be paid on the debt. The Proposed Regulations will reduce or eliminate the benefits of this technique in several respects, if enacted.

Example: An irrevocable life insurance trust holds a large policy on decedent. On death the proceeds are collected and the trust loans money to the decedent’s estate to pay estate tax pursuant to a Graeginloan and all interest to be paid under the loan is a deduction for the estate. Under the Proposed Regulations this debt may have to be discounted using present value technique that reduces or eliminates any benefit from an estate tax reduction perspective.

The estate should have real liquidity issues (e.g. a real family business, real estate or other non-liquid asset that is being safeguarded; a securities FLP likely won’t suffice.)[9] If the estate did not need the loan to pay estate tax then it faced the risk of IRS challenge. The administrative expenses must be reasonable and necessary. Under current law the IRS may still question whether the Graegin loan in the context of the particular estate is reasonable and necessary. But the Proposed Regulations would amplify this requirement (see next section).

Graegin loans may be used to cover the entire estate-tax obligation, and the interest is a deductible expense; provided that the loan is bona fide and “actually and necessarily” incurred.

Interest On Certain Loan Obligations Incurred by an Estate.

While the election under Section 6166 allows estates to defer the payment of estate tax up to 14 years, it has two potential disadvantages: (1) it does not generally apply to a decedent’s entire estate (just closely held businesses and only if strict requirements are met), and (2) the interest charged on the deferred amount of estate tax is not deductible as an expense under IRC Section 2053, although a low interest rate is applied.

The Preamble to the Proposed Regulations 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 liquidity has been created intentionally prior to the creation of the loan obligation to pay estate expenses and liabilities, the underlying loan may be bona fide but “most likely will not be found to be actually and necessarily incurred in the administration of the estate.”

The Proposed Regulations provide that interest expense is deductible only if:

1. The interest rate on and the terms of the underlying loan (whether between related or unrelated parties), including any prepayment penalty, are reasonable given all the facts and circumstances, and comparable to an arms-length loan transaction.
2. The underlying loan is entered into by an executor of the decedent’s estate acting in the capacity of executor or, if no executor is appointed and acting, the person accountable for satisfying the liabilities of the estate.
3. The lender properly includes amounts of paid and/or accrued interest including original issue discount as determined under sections 1271 through 1275 and the regulations thereto, particularly if the lender is a family member of the decedent, a related entity, or a beneficiary of the decedent’s estate or trust (as defined in §20.2053-1(b)(2)(iii)).
4. The loan proceeds are used to satisfy estate liabilities that are essential to the proper settlement of the estate, including, but not limited to, the Federal estate tax liability.
5. The loan term and payment schedule correspond to the estate’s anticipated ability to make the payments under, and to satisfy, the loan, and the loan term does not extend beyond what is reasonably necessary;
6. The only practical alternatives to the loan are the sale of estate assets at prices that are significantly below-market, the forced liquidation of an entity that conducts an active trade or business, or some similar financially undesirable course of action.
7. The underlying loan is entered into when the estate’s liquid assets are insufficient to satisfy estate liabilities, the estate does not have control (within the meaning of section 2701(b)(2)) of an entity that has liquid assets sufficient to satisfy estate liabilities, the estate has no power to direct or compel an entity in which it has an interest to sell liquid assets to enable the estate to satisfy its liabilities, and the estate’s assets are expected to generate sufficient cash flow or liquidity to make the payments required under the loan.
8. The estate’s illiquidity does not occur after the decedent’s death as a result of the decedent’s testamentary estate plan to create illiquidity; similarly, the illiquidity does not occur post-death as a deliberate result of the action or inaction of the executor who then had both knowledge or reason to know of the estate tax liability and a reasonable alternative to that action or inaction that could have avoided or mitigated the illiquidity.
9. The lender is not a beneficiary of a substantial portion of the value of the estate, and is not an entity over which such a beneficiary has control (within the meaning of section 2701(b)(2)) or the right to compel or direct the making of the loan;
10. The lender or lenders are not beneficiaries of the estate whose individual share of liability under the loan is substantially similar to his or her share of the estate.
11. The decedent’s estate has no right of recovery of estate tax against, or of contribution from, the person loaning the funds.

The IRS appears to be targeting actions taken after death that may create illiquidity, as well as estate planning during the decedent’s lifetime that produces post-death illiquidity. For example, there may be significant impacts to estate plans with irrevocable life insurance trusts (ILITs) which are commonly used to create a source of liquidity outside of a decedent’s taxable estate. Under the Proposed Regulations, without a modification to exclude ILITs, such a pre-death funding arrangement will limit an estate’s interest deductions.

The Proposed Regulations also provide “a nonexhaustive list of factors” to consider in determining “whether interest expense payable pursuant to such a loan obligation of an estate satisfies the requirements of Sections 20.2053-1(b)(2) and 20.2053-3(a).”

How will this be determined? Certainly, contributing marketable securities into an FLP or LLC and thereafter claiming liquidity needs to support borrowing funds to pay estate taxes will not likely succeed. If just prior to death the taxpayer makes gifts of liquid assets while retaining primarily non-liquid real estate and business holdings, a later interest expense on a borrowing to pay estate tax, may not be sustained. However, the factual determinations in less obvious cases may be difficult to determine. What if the gifts or uses of liquid assets were reasonable and necessary due to external factors beyond the taxpayer’s control? This could create additional exposure to practitioners where beneficiaries of estates that lose their interest deduction may seek to blame the tax advisor.

Many estate planners and attorneys will focus on the present value adjustments under these Proposed Regulations, and how such present value adjustments will apply beyond the concerns about the Graeginloans. Some commentators have expressed concern that certain aspects of the Proposed Regulations are excessive. For example, estate planning during the decedent’s lifetime that intentionally creates illiquidity, a common planning approach to enhance discounts, they argue should not be used to prevent the estate from later deducting interest on post death loans.

But the position of the Proposed Regulations on interest deductions may be supported by prior case law such as Koons v. Commissioner and Black v. Commissioner.[10]^,[11] In the above cases, the courts agreed with the IRS’s position that interest on related-party borrowing that the estates undertook to pay estate expenses was not deductible because the loan was not necessary given other readily available liquid assets.

Interest on Tax and Penalties Owed.

In general, interest is payable at the underpayment rate in Section 6621 (presently being ___% as of Dec. 2023) on (a) any amount of unpaid federal tax, and (b) any unpaid additions to tax, additional taxes, and penalties.

The Proposed Regulations reconfirm that interest on estate tax installment payments that are authorized pursuant to Section 6166 are not deductible for estate tax purposes.  The Proposed Regulations state that other “non-Section 6166 interest” may be deductible when payable in connection with the administration of an estate, including interest that accrues on or after the decedent’s date of death on any unpaid tax or penalties (penalties is defined as any unpaid additions to tax, additional taxes, and penalties.)

The Proposed Regulations if finalized would also deny deductibility if interest accrues on any unpaid tax or penalty and the interest expense is attributable to an executor’s negligence, disregard of the rules or regulations, or fraud with intent to evade tax.  The Proposed Regulations provide that in this scenario the interest expense is neither actually and necessarily incurred in the administration of the estate, nor essential to the proper settlement of the estate, and therefore is not deductible.

Conclusion.

There is still time for the IRS to address the concerns that planners have with the Proposed Regulations before they take effect later this year. Perhaps most notably are concerns that the IRS seeks to hinder the viability of common estate planning strategies, such as reducing an estate’s ability to borrow money after death to pay estate taxes. The new rules would apply to deaths after the final rule publication date, which is expected to be some time in 2023.

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^[1] Guidance Under Section 2053 Regarding Deduction for Interest Expense and Amounts Paid Under a Personal Guarantee, Certain Substantiation Requirements, and Applicability of Present Value Concepts, 87 Fed. Reg. 38331 (proposed June 28, 2022) (to be codified at 26 C.F.R. 20).

^[2] Electronic or written comments must be received by September 26, 2022. The public hearing is being held by teleconference on October 12, 2022, at 10 a.m. EST.

^[3] Final regulations amending the regulations under Section 2053 (TD 9468) were published in the Federal Register (74 FR 53652) on October 20, 2009 (2009 Final Regulations).

[4] Treas. Reg. §20.2053-4.

[5] See IRC Section 6511(a).

^[6] Exceptions for claims and counterclaims in related manner.

^[7] Exceptions for claims totaling not more than $500,000.

^[8] See Estate of Graegin v. Commissioner, T.C. Memo. 1988-477.

[9] TAM 200513028.

[10] Estate of Koons v. Commissioner (Koons II), 2017 U.S. App. LEXIS 7415 (April 27, 2017) (upholding Estate of Koons v. Commissioner, 2013 Tax Ct. Memo LEXIS 98 (T.C., 2013)).

[11] Estate of Black v. Commissioner, 133 T.C. 340 (2009).