ACTEC’s Comments on Section 2053 – Proposed Estate Tax Regulations
“ACTEC’s comments on Section 2053, Proposed Estate Tax Regulations,” that’s the subject of today’s ACTEC Trust and Estate Talk.
This is Doug Stanley, an ACTEC Fellow from St. Louis, Missouri. On September 22, 2022, the American College of Trust and Estate Counsel, ACTEC, submitted comments to the IRS regarding the proposed regulations under IRS Code Section 2053. The proposed regulations affect estates of decedents seeking to deduct funeral expenses, administrative expenses, and/or certain claims against the decedent’s estate. Today, ACTEC Fellow Kevin Matz of New York City will give us an overview of ACTEC’s comments. Kevin is the chair of ACTEC’s Business Planning Committee who worked on the comments with the Washington Affairs Committee. Welcome, Kevin.
Thank you, Doug, and hello everyone. So, on June 28, 2022, the U.S. Department of Treasury and the IRS published proposed regulations under Internal Revenue Code Section 2053 concerning estate tax deductions for estate administration expenses and claims. Now, these proposed regulations did a lot. They basically do five different things or did five different things. They provide guidance on use of present value principles and determine any amount deductible by an estate for funeral expenses, administration expenses, and certain claims against the estate. In addition, proposed regulations provide guidance on the deductibility of interest expense accruing on tax and penalties owed by the estate.
And also, notably on interest expense accruing on certain loan obligations incurred by the estate. Further, the proposed regulations also amend and clarify the requirements staturing 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 the decedent’s personal guarantee. Now, if these proposed regulations are adopted in final form, they will affect the estates of decedents dying on or after the date of publication of such final regulations. So, let’s drill down. Before we talk about ACTEC’s comments, let’s drill down on the proposed regulations a little bit just to set the table a bit more.
Proposed 2053 Regulation: Present Value Three-Year Grace Period
So, number one – it’s mentioned there’s a present value concept subject to a three-year grace period. Now, going back, go on a time-warp to 2009, we had final regulations issued under Section 2053 which reserved to provide future guidance on the application of present value principles in determining the amount deductible under Section 2053. Fast forward to these proposed regulations 13 years later, and what these proposed regulations do is that they are 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. That three-year window is referred to as a “grace period.”
So, when you get beyond three years, you have a present value contest. What’s the interest rate? Post regulations say that 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. Now, the proposed regulations require a supporting statement to be filed with a Form 706 estate tax return. So, you need calculations of the present value. In addition, the proposed regulations provide that the expected date or dates of payments generally must be identified in a written appraisal document.
Proposed 2053 Regulation: Interest Expense Accruing on Estate Tax and Penalties
The second concept of the proposed regulations is interest expense accruing on tax and penalties owed by the estate. So, according to the preamble, the IRS has determined that the amount of interest payable on the unpaid estate tax in connection with an extension under Section 6161, or deferral under 6163, is necessarily incurred in the administration of the estate. In addition, again this is really just setting the table, the proposed regulations acknowledge something I think was already known – that interest on estate tax installments payments that are authorized under Section 6166 are not deductible for estate tax purposes. It basically uses that to coin the term “non-Section 6166 interest.”
Now, upon noting that, then the proposed regulation says – “Okay, let’s look at everything else” – In connection with non-Section 6166 interest. And it says, “if it has accrued, the interest has accrued an unpaid tax and penalties in connection with an underpayment of tax or deficiency, and is attributable to an executer’s negligence, disregard of the rules and regulations, or fraud with intent to evade tax, the interest expense is not an expense actually and necessarily accruing administration of the estate.” Accordingly, the interest on taxes is not deductible to the extent that the interest is attributable to the fact that there’s negligence, disregard of applicable rules and regulations, or fraud with intent to pay tax.
Proposed 2053 Regulation: Liquidity and Illiquidity
Now let’s go to the meatier stuff. Next up, interest expense accruing on certain loan obligations incurred by an estate. Now, the proposed regulations take aim and fire at the use of so-called “Graegin Loans.” Right there, it’s referenced there. It’s the famous Estate of Graegin vs. Commissioner case. Tax court memorandum will tell you from 1988-477 and perceived attempts by estates to quote-unquote, and this is in the actual preamble to the proposed regulations, “concoct” (that is a term of art in the preamble) illiquidity. Not liquidity, but 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. (Listen to the podcast Paying and Reducing Estate Tax with a Graegin Loan for more information.)
Now, although the IRS’s concern is understandable, the problem is that the proposed regulation really goes way too far. Now, the preamble to the proposed regulations acknowledges that some estates face genuine liquidity issues. But they can necessarily find a means to satisfy their liabilities. And incurring a loan obligation in which the interest accrues may be the only or the best way to obtain the necessary liquid funds.
However, the preamble to the proposed regulations continues that if illiquidity has been created intentionally, and get this part, whether in the estate planning or a body of the estate with knowledge or reason to know the estate tax liability. So, we’re not just talking about post-death, we’re talking about pre-death too, ladies and gentlemen. Prior to the creation of a loan obligation to pay estate expenses and liabilities, the underlying loan may be bona fide (this is again per the preamble), but then most likely per the preamble will not be found to be actually and necessarily incurred in the administration of the estate.
Proposed 2053 Regulation: Deductible Interest Expense
Now, proposed regulations provide that the interest expense is deductible only if, among other things, the loan terms are actually and necessarily incurred in the administrations of the decedent’s estate and are essential to the proper settlement of the decedent’s estate. For the proposed regulations providing a non-exclusive list of factors to balance, 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 to any control by such a beneficiary. And a time when there’s no available alternative to obtain necessary liquid funds to satisfy estate obligations. The preamble posits an example where either the need for the loan or any loan terms are quote-unquote “contrived.” Again, a word in the preamble to generate or increase the amount of deduction for the interest expense. In that case, the interest is not deductible.
Further, according to the proposed regulations, if a loan obligation carried an extended term, 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.
Now, here’s another thing – the IRS appears to be extending scrutiny not only to actions taken after death that may create illiquidity, but also to estate planning during the decedent’s lifetime which produces illiquidity post-death as a byproduct. This is seriously problematic because it overlooks that there may be significant non-tax reasons. For taxpayers to structure their holdings in ways that may not be liquid including, among other things, to ensure that subsequent generations don’t sell inherited business interests that the decedent has spent a lifetime building, sometimes from scratch.
Further, what about an ILIT, Irrevocable Life Insurance Trust? One of our favorite devices to produce liquidity post-death in an otherwise illiquid estate. An ILIT is commonly employed of course as a source of liquidity outside of the decedent’s taxable estate. And how does it work? You have the trustee of the ILIT often lending funds obtained through the life insurance proceeds to the executor to help fund the payment of estate taxes. The question, in that situation, is the interest on that loan deductible, or are there limitations on it? Again, an area that under the proposed regulations left a major question mark. Next point, the fourth point of the proposed regulations – there are changes in regard to staturing the value of a claim against an estate.
Proposed 2053 Regulation: Appraisals and Claims Against an Estate
According to the preamble, the IRS considers the application of a so-called qualified appraiser and qualified appraisal requirement in this context. Proposed regulations instead require a written appraisal signed under penalties of perjury that reflect the current value of the claim in the Form 706 estate tax return as being completed. The last point in the proposed regulations, before we delve into ACTEC’s specific comments, is the deductibility of amounts paid under a personal guarantee. What the proposed regulations do is they set the baseline or repeat the baseline that a claim founded upon a decedent’s personal guarantee of another’s death is acclaimed founder of a promise and accordingly must satisfy applicable requirements.
Specifically, the guarantee must have been bona fide and exchanged for adequate and full consideration of money and money’s worth as opposed to gratuitous even if enforceable under applicable state law. In addition, the proposed regulations provide that the estates’ right of contribution or reimbursement will reduce the amount deductible.
Now, the proposed regulations go on though. They provide what seems to be a bright line rule, that is even to the agreement to guarantee a bona fide then of an entity in which the decedent has control within the meaning of Section 2071(b)(2) of the Internal Revenue Code, at the time the guarantee satisfies the requirement that the agreement be in exchange for full and adequate consideration in money or money’s worth.
Alternatively, the proposed regulations then say that this requirement also is satisfied at the time the guarantee is given if the maximum liability of the decedent under the guarantee did not exceed the fair market value of the decedent’s interest in the entity. So, you have those two items listed. What about everything else? Silence. And the concern with silence is it could be construed to create a negative inference, right? That the decedent’s personal guarantee and circumstances that fall outside these circumstances may not give rise to estate tax deduction. Even though the decedent may have had a substantial interest in the entity.
ACTEC Comments on Proposed 2053 Regulation: A Balanced Approach
So, ACTEC’s comments address the last three of the topics that I just mentioned.
First off, I’m going to do very high-level. There’s a lot more nuance and I invite everyone to review ACTEC’s comment letter on this. Regarding interest expense and certain loan obligations, as noted, the proposed regulations express concern about perceived attempts by estates to produce illiquidity. That can cause estates to enter into loan agreements with related parties to generate interest deductions under Section 2053. Although, as ACTEC acknowledged, Treasury’s concern is understandable. The prescription that proposed regulations go beyond what is necessary to address this concern and, if adopted in its present form, would also penalize estate and other planning that is significantly motivated by non-tax consideration.
So, as far as ACTEC’s approach, ACTEC suggests an approach to balance these considerations that focuses, in general, on the presence of a significant non-tax purpose for entering into the loan – certain absolute carveouts for many of the limitations of deductibility of interest. In a nutshell, if there’s planning during a lifetime that produces illiquidity, that’s okay. That should not be problematic in ACTEC’s view, even if dealt with within three years of death, as long as there’s a significant non-tax reason for the planning. What if it’s more than three years before the decedent’s death? That should be per se “okay” because it’s so far removed from the date of death.
ACTEC Comments on Proposed 2053 Regulation: Irrevocable Life Insurance Trusts and Appraisals
Also, when it talks about funding arrangements, for life insurance, Irrevocable Life Insurance Trusts, or other arrangements with respect to business entities to the same effect – that too should be completely exonerated and should not create or pose any risk to limitations on deductibility. The second note of ACTEC’s comments addresses written appraisal documents. So, as mentioned, in that context, ACTEC recommends there should be no requirement that a written appraisal document be signed under penalties of perjury. Why? A penalty of perjury requirement does not appear anywhere in the Internal Revenue Code. ACTEC further believes that the word quote-unquote – “appraisal” – itself is unnecessarily restrictive and recommends that it should not be used, except perhaps as an example among several options.
ACTEC Comments on Proposed 2053 Regulation: Loans
Then, lastly, regarding amounts paid pursuant to the decedent’s personal guarantee – this comment letter points out that under case law, tax court cases and the like, the guarantor’s right to subrogation is considered to constitute adequate and full consideration if the guarantor had a bona fide expectation that the loan be paid by the borrower or that the guarantor would be reimbursed if the guarantor were required to make the payment on the loan guarantee. In the view of ACTEC, the regulations should reflect this case law and that any examples in the regulations should be expressly non-exclusive safe harbors. So that, Doug, is my summary of ACTEC’s comments from the proposed Section 2053 regulations with some background on what those regulations provide.
Thank you, Kevin, for sharing your knowledge with us today.
You may also be interested in:
- Paying and Reducing Estate Tax with a Graegin Loan
- Treasury and IRS’s Priority Guidance Plan
- Estate Planning Opportunities in a Time of Rising Interest Rates
- Understanding Life Insurance Policy Ownership
- Third-Party Created Irrevocable Trusts: Protections and Pitfalls
- Funeral Arrangements and Disposition of Human Remains
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