Recent Case Illustrates the Benefits of Borrowing to Pay Estate Taxes
In Estate of Gilman, 1 the Tax Court permitted an estate to deduct the interest and closing costs associated with the portion of a loan obtained to enable the estate to pay estate taxes. The interest and closing costs associated with the portion of the loan used to pay nondeductible estate expenses were not deductible.
When Howard Gilman died in 1998, his estate was valued at approximately $611 million. The estate consisted of several apartments, $700,000 of cash and cash equivalents, and 100% of the stock in a holding corporation owning approximately 50 businesses. Prior to his death, Gilman formed the Howard Gilman Foundation.
Gilman's will provided for cash bequests of approximately $30 million and directed that the residue of his estate was to be distributed to his foundation. Gilman's will provided that his executors were not to receive commissions or fees for serving as executors but that they were to continue to receive compensation from the Gilman businesses for serving as officers and directors.
The executors received tax advice that by transferring the stock, assets, and liabilities of the Gilman businesses owned by Gilman's holding company to a newly created limited liability company (“LLC”) through a series of tax-free mergers, the estate would save $160 million of capital gains taxes that would otherwise be incurred upon the sale of the Gilman businesses by the estate. In January 1999, the executors implemented the restructuring plan and then merged the holding company into the foundation. The foundation thus became the sole member of the LLC. The executors of Gilman's estate became the managers of the LLC and directors of the foundation.
As part of the restructuring, the estate received $143 million of promissory notes from several of the Gilman businesses. The notes called for the annual payment of interest and the payment of the entire principal amount on January 31, 2004. Shortly after the restructuring was implemented and on account of a decrease in the cash flow of the Gilman businesses, the obligor-businesses and the estate amended the promissory notes to provide that the payment of interest on the notes could be deferred at the option of the obligors. The executors expected to use the interest and principal payments on the notes to pay estate taxes and expenses. After the restructuring, in addition to the promissory notes, the assets of the estate consisted of $40 million dollars of cash and real estate.
On April 1, 1999, the estate elected under Section 6166 to pay the federal estate tax in ten annual installments commencing on October 3, 2003. The estate made a similar election permitted under New York law to pay the New York estate tax in ten annual installments. However, upon audit in 2001, the IRS advised the executors that as a result of the transfer of assets to the LLC, the estate's ability to continue to defer the payment of estate tax under Section 6166 was doubtful. The executors therefore decided to pay the estate taxes in full. The estate borrowed $38 million from a bank in order to pay federal and New York estate taxes and expenses, which included compensation to be paid to the executors for services they rendered to the LLC. The loan was payable over ten years with fixed payments of interest and principal. The closing costs on the loan were $200,000.
The issue in the case was whether the loan proceeds were necessary for the purpose of paying estate taxes and deductible administration expenses of the estate. If the loan was necessary, the interest and closing costs paid on the loan would be deductible under Section 2053.
The court began its analysis by discussing whether the payment of compensation to the executors under the facts of this case was a permissible estate expense. The court found that after the restructuring, the Gilman businesses were no longer owned by the estate but rather were owned by the LLC. The court held that after the restructuring, the management services related to the Gilman businesses were rendered by the executors in their capacity as managers of the LLC and not as executors. The court stated that “using executors to run a commercial enterprise does not convert expenses of the enterprise to estate expenses.” According to the court, the transfer of the businesses from the estate to the LLC severed the relationship the executors had with those assets in their capacity as executors.
The court noted that Article 10 of Gilman's will prohibited the executors from receiving commissions or fees for serving as executors, but they were to entitled to receive compensation for serving as officers and directors of the Gilman businesses. The court therefore held that since the executors were not entitled to compensation from the estate, it was not necessary for the estate to borrow funds to compensate them.
The court next discussed whether the loan was necessary to pay estate taxes. The court found that after paying the cash bequests, the remaining assets of the estate were illiquid. In addition, the court held that the executors acted reasonably in engaging in the restructuring that would result in significant tax savings upon a sale of the Gilman businesses. The court did not believe that the executors were required to forgo the restructuring transaction and attempt to sell the illiquid assets. The court also noted that it was necessary for the estate to obtain the loan after the unanticipated decrease in the cash flow of the Gilman businesses caused the interest payments on the notes to be deferred. The court held that the loan was necessary to enable the estate to pay estate taxes and permissible estate expenses.
However, the court concluded that the loan was not necessary beyond January 31, 2004, the maturity date of the promissory notes due from the Gilman businesses. The court found that after the repayment of the notes, the estate would have sufficient liquidity to pay the estate taxes. Thus, the court held that the interest accruing on the loan after January 31, 2004 was not deductible. In addition, the court ruled that a portion of the closing costs was deductible in an amount equal to the portion of the entire loan used to pay estate taxes and permissible estate expenses.
The Gilman case stands for the proposition that a deduction is permitted for estate tax purposes for interest to be paid on a bona fide loan to the extent that the loan is necessary to pay legitimately incurred obligations of the estate. Often, however, the courts tend to take a hard look to see if the borrowing is really necessary. Here, the executors succeeded in establishing that it was.
If the amount of interest to be paid is ascertainable from the beginning, then the full amount of the interest to be paid is permitted as a deduction rather than the discounted present value of the interest payments, thereby eliminating the need to file periodic claims for refund or encountering statute of limitations issues. In order for the interest to be ascertainable, the loan must provide for a fixed rate as opposed to an adjustable rate of interest, and the loan must prohibit the prepayment of the amount borrowed unless all the interest that otherwise would have been due is also paid upon prepayment. 2
1 TC Memo 2004-286, RIA TC Memo ¶2004-286
2 See Estate of Graegin, TC Memo 1988-477, PH TCM ¶88477, 56 CCH TCM 387 ; Ltr. Ruls. 200020011, 199952039, and 199903038.
Frank S. Baldino is an attorney at Lerch, Early & Brewer in Bethesda, Maryland who practices in the areas of estate planning and probate administration and who co-chairs the firm's Estate Planning and Probate Group. He has extensive experience in the areas of estate planning, charitable giving, estate planning for non-U.S. citizens, tax planning with respect to retirement plans and stock options, asset protection planning, business succession planning and estate and trust administration. Frank may be contacted at 301-657-0715 or firstname.lastname@example.org.