More On Tax Planningfrom The Advisor's Professional Library
- IRAs: In General Individual Retirement Accounts are highly popular tools for contributing funds that grow on a tax deferred basis. Depending on the type of IRA, the accumulation can be tax free.
- ETF Taxation The use of ETFs may be attractive to certain investors. The tax advantages may make them even more attractive.
Do you have clients whose estates face a liquidity crisis because they’re loaded with stock in a family company or other illiquid assets? A Graegin loan may be just the technique you need to prevent unwanted liquidation of estate assets to pay estate taxes and other expenses. Add life insurance and the Graegin loan’s positive impact on estate liquidity can be levered up significantly.
When Are Loan Expenses Deductible by an Estate?
To be deductible, loan expenses must be allowable by the laws of the state where the estate is being administered. Additionally, the regulations require that the expense be “actually and necessarily, incurred in the administration of the decedent's estate.” [Treas. Reg. §20.2053-3(a)] The regulations go on to specify that “administration of the decedent’s estate” means the following activities: The collection of assets, payment of debts, and distribution of property to the persons entitled to it. One such valid reason is the prevention of forced sale of assets.
The Graegin Case
In Graegin [Graegin Est. v. Commissioner, 56 TCM 387 (1988)], Cecil and Helen Graegin married late in life. As part of an antenuptial agreement, they created two trusts—Cecil’s trust and Helen’s trust. Cecil’s trust was funded with 5,130 shares of Graegin Industries Inc. stock, worth $564,300. Under Cecil’s trust, after his death the Graegin Industries stock was to be distributed to his chosen beneficiaries, including children and grandchildren from a previous marriage.
Cecil predeceased Helen. After Cecil died and his estate paid its non-estate tax debts, there was only about $20,000 in liquid assets left to pay his $204,218 estate tax bill. Rather than sell the Graegin stock to pay the estate tax bill, his executors borrowed $204,218 to pay the estate tax bill from Graegin Corp., a wholly owned subsidiary of Graegin industries.
The unsecured note bore 15 percent interest per annum, but interest and principal were to be paid in a single payment 15 years later. The 15-year term was equal to Helen’s expected life span. They anticipated that dividends paid on the stock to Cecil’s trust, and assets remaining in Helen’s trust at her death would be used to repay the loan.
On Cecil’s estate tax return, his executor deducted as an administration expense the $459,491—the amount of interest that would be paid on maturity of the note.
Is the Interest Expense on a Graegin Loan Deductible?
Yes, if the transaction is structured properly the interest is currently deductible even if it won’t be paid for many years. In the Graegin case,
The court also considered the reasonableness of the loan’s terms and, despite its uneasiness with the “no prepayment” term, it decided that the character of Cecil’s estate justified the terms of the loan as a necessary administrative expense.
What Do Graegin Loans Have to Do With My Life Insurance Practice?
The Graegin case didn’t involve any life insurance. So how does it relate to your life insurance practice?
In Graegin, the trust satisfied its liquidity needs by borrowing from an unrelated corporation. But that’s not the only scenario where a Graegin loan makes sense. In fact, Graegin loans don’t need to be an afterthought when your client dies and his or her estate is having trouble meeting its estate tax (or other) expenses. You can work a Graegin loan into an estate plan where liquidity is anticipated to be a need post-death.
How will you fund the Graegin loan? Life insurance held in an irrevocable life insurance trust (ILIT). Then, when the insured dies, the estate can take a Graegin loan from the ILIT and pay its tax bill while generating a sizable current deduction for the estate. In a very large estate, the deduction could run well into the millions.
A Closing Word of Caution
An ILIT should never pay the estate’s expenses directly. Do that and you risk pulling the ILIT’s assets back into the estate, eliminating its primary purpose. Also, although the Graegin loan is a permissible estate planning device, the IRS would be happy to challenge the loan as being not bona fide or necessary in the administration of the estate. Both the ILIT and the terms of the loan must be drafted carefully to avoid undue IRS scrutiny.
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See also The Law Professor's blog at AdvisorFYI.