Court Disallows Interest Deduction on Graegin Loan
In Estate of Koons, 1 the Eleventh Circuit Court of Appeals upheld a decision of the United States Tax Court in holding that interest paid pursuant to a Graegin loan from a related entity was not allowable as an estate tax administrative deduction because the court held that the loan was not necessary.
The revocable trust of John Koons owned 46.9% of the voting stock (and 51.5% of the nonvoting stock) of Central Investment Corp. (CIC) which primarily bottled and distributed Pepsi products and also sold vending machine items. The children of Mr. Koons owned most of the remaining stock in CIC either directly or through trusts, while other family members and trusts held the remaining shares. In order to settle litigation between CIC and Pepsi, CIC agreed to sell its Pepsi assets and its vending machine business to an affiliate of Pepsi for payments of approximately $352 million and $50 million to settle the lawsuit.
The children of Mr. Koons were displeased with his plan to place the proceeds from the sale of the CIC stock in CIC, LLC, a newly formed limited liability company (LLC) that would be wholly owned by CIC, where the proceeds would be invested in new businesses run by professional advisors. As a result of their displeasure, the children conditioned the sale of their CIC stock on the LLC agreeing to redeem their interest in the LLC after the stock sale.
Another entity, CIC Holdings LLC, was created to facilitate the sale and was merged into the LLC after the sale was completed. The Pepsi affiliate paid the purchase price to CIC Holding and, after the sale, CIC Holding was merged out of existence and into the LLC. As a result of the merger, the LLC acquired:
(1) $352 million in proceeds from the sale of the CIC stock.
(2) $50 million that PepsiCo paid in the settlement of the lawsuit.
(3) The CIC assets that were unrelated to its soda and vending machine businesses that the Pepsi subsidiary did not acquire.
The unrelated assets that the LLC retained included four businesses, three of which the LLC sold shortly after the sale. CIC distributed its 100% membership interest in the LLC to CIC shareholders in proportion to their interests in CIC. The redemptions of the interest of the children of Mr. Koons in the LLC were completed following Mr. Koons' death. Following the redemptions, Mr. Koons' revocable trust owned 70.42% of the voting interest and 71.07% of the nonvoting interest of the LLC.
The assets of the revocable trust of Mr. Koons comprised the majority of the asset of his estate with the revocable trust's interest in the LLC being its primary asset. The estate's remaining liquid assets, however, were insufficient to pay its tax liability. The trustees of the revocable trust declined to direct a distribution of the revocable trust's interest in the LLC to pay the estate tax liability, believing that immediate payment would hinder the LLC's plan to invest in operating businesses.
As a result, the trustees of the revocable trust obtained a loan from the LLC for $10.7 million in exchange for a promissory note bearing an annual interest rate of 9.5%. No payment was due for 18 years, and principal and interest were scheduled to be repaid in 14 installments over seven years. The promissory note did not allow prepayments. Because the revocable trust's primary asset was its interest in the LLC, it anticipated that the loan would be repaid with distributions from the LLC to the revocable trust. The LLC had over $200 million in liquid assets at the time of the loan.
The estate filed its tax return claiming a deduction of approximately $71.5 million for interest on the loan as an administrative expense. Based on a valuation report, it also reported the market value of the revocable trust's interest in the LLC to have been approximately $117 million as of the date of death of Mr. Koons.
The IRS determined an estate tax deficiency of approximately $42.8 million and a generation-skipping transfer tax deficiency of approximately $15.9 million due to its determination that the interest payment under the promissory note was not entitled to a deduction and that the estate tax return understated the value of the revocable trust's interest in the LLC.
Reg. 20.2053-3(a) provides that an estate is allowed to deduct expenses that are "actually and necessarily incurred in the administration of the decedent's estate." The Regulation clarifies that "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." In Estate of Graegin, 2 the Tax Court stated: "Expenses incurred to prevent financial loss to an estate resulting from forced sales of its assets to pay estate taxes are deductible administration expenses." Conversely, interest payments are not a deductible expense if the estate would have been able to pay the debt using the liquid assets of one of its entities, but instead elected to obtain a loan that it will eventually repay using those same liquid assets.
The court discussed the case law in this area and provided a two-pronged test for determining whether interest payments are necessary estate tax administration expenses. Under this test, interest payments are not necessary expenses where:
(1) The entity from which the estate obtained the loan has sufficient liquid assets that the estate can use to pay the tax liability.
(2) The estate lacked other assets such that it would be required to eventually resort to those liquid assets to repay the loan.
The court then applied this two-pronged test to the facts of the case to determine whether the interest payments were necessary estate tax administration expenses.
With respect to the first prong, the court assumed that if the estate had been forced to sell its interest in the LLC, it would have been required to do so at a loss. Therefore, the court stated that if the estate's only option in this case had been to sell the revocable trust's interest in the LLC, the loan would have been necessary and the interest payments on that loan would have been necessary estate tax administration expenses.
The IRS argued that because the revocable trust had 70.42% voting control over the LLC, and because the LLC had over $200 million in liquid assets, the revocable trust could have ordered a pro rata distribution to obtain these funds and pay its tax liability. The estate contended, however, that the funds of the LLC were not available because the revocable trust did not have the legal authority to order a pro rata distribution from the LLC; as a majority shareholder, it has a fiduciary duty not to misuse its power by promoting its personal interests at the expense of corporate interests. The estate asserted that, due to its fiduciary duty, the revocable trust would not have been permitted to order a distribution from the LLC.
The estate further contended that Mr. Koons had a long-term investment philosophy to which the LLC's members and board of managers adhered. That philosophy required the LLC to retain liquid assets for investment purposes. The estate argued that the revocable trust would have breached its fiduciary duty by ordering distributions to the detriment of this business model.
The court stated that whether the estate had funds available to it depends on whether the revocable trust was legally able to order a distribution. The court examined relevant state law, in this case Ohio, and concluded that under Ohio law a majority interest holder has rights associated with its interest, and these rights entitle the holder to take action beneficial to it as long as the minority interest holder benefits equally. The court concluded that under Ohio law the revocable trust would not have breached its fiduciary duty to the other members of the LLC if a pro rata distribution was made because all the members of the LLC would have benefited equally. The court therefore determined that the estate had access to sufficient funds to pay its tax liability.
Turning to the second prong of the test, the court stated that a loan is not unnecessary merely because the estate had access to a related entity's liquid assets and could have used those assets to pay its tax liability. Instead, a loan is unnecessary if the estate lacks any other assets with which to repay the loan, and inevitably will be required to use those same assets to repay it. The court stated that where the estate merely delays using the assets to repay the loan rather than immediately using the assets to pay the tax liability, the loan is an "indirect use" of the assets and is not necessary. The court found that the loan in this case was an "indirect use" of funds and therefore was not necessary.
The court concluded that aside from the revocable trust and the revocable trust's interest in the LLC, the estate lacked sufficient funds to repay the loan. In addition, the court found that the estate's loan repayment schedule was designed to enable the revocable trust to repay the loan out of its distributions from the LLC. Moreover, the court stated the revocable trust's distributions from the LLC would be used to satisfy the estate's tax obligations regardless of whether the estate paid its tax liability immediately or obtained a loan and then repaid the tax liability gradually. Furthermore, the court found that the LLC would be paying disbursements to the revocable trust only to have those payments returned in the form of principal and interest payments on the loan.
Finally, the court found that the same entity was on both sides of the transaction, resulting in the LLC in effect paying interest to itself. The court concluded that the loan had no net economic benefit aside from the tax deduction and, therefore, found that these facts demonstrated that the loan was not necessary.
The analysis and holding in this case is similar to that in Black, 3 so the holding in this case is not surprising. The loan in this case was more extreme than the loan in Black because the loan in this case had a 25-year term with no payments for 18 years and generating interest payments of $71.4 million on a loan of only $10.7 million. These facts may have triggered the IRS audit.
1 119 AFTR2d 2017-1609 (CA-11, 2017)
2 TC Memo 1988-477
3 133 TC 340 (2009)
Frank Baldino is an estates and trusts attorney who helps people throughout the greater Washington, DC area protect assets for their families and future generations through careful estate tax planning. For more information, contact Frank at 301-657-0175 or firstname.lastname@example.org.
This article originally appeared in the August 2017 edition of Estate Planning, a monthly periodical directed to estate planning professionals that offers readers the newest and most innovative strategies for saving taxes, building wealth, and managing assets.