Estate Entitled to Deduct Interest Expense for Loan to Pay Estate Tax

An estate was entitled to deduct its interest expense because the loan was actually and reasonably necessary to the administration of the estate, the Tax Court has held (Estate of Duncan v. Commissioner, Dec. 58,797(M), TC Memo. 255).

After inheriting an interest in his grandfather's oil and gas business, the decedent started his own oil and gas company. He eventually transferred the company, along with his interest in a ski resort and several other assets, to a revocable trust (Trust 1).

Pursuant to the terms of Trust 1, after the decedent's death, the trust was to pay the estate's obligations and taxes before being divided into separate trusts for the benefit of the decedent's children. Following the decedent's death, the trust sold all of its liquid assets; however, after the sale, it still needed an additional $6 million to pay the estimated estate tax.

In order to avoid selling illiquid assets, the trust borrowed the necessary funds from a separate trust (Trust 2) over which the decedent held a general power of appointment. Because of the difficulty of predicting the income stream from an oil and gas business, the trusts agreed on a 15-year bullet loan with an interest rate of 6.7 percent, which was set by a corporate fiduciary's banking department and was 1.55 percent below prime.

The estate's loan was bona fide because there was a genuine intention to create a debt with a reasonable expectation of repayment, the court ruled. According to the IRS, the loan had no economic consequence because the borrower and the creditor trusts were identical.

Although both trusts had the same trustees and beneficiaries, the court noted that it was not possible to combine the trusts into a single entity or to comingle their assets. The trusts had different terms and different grantors. Combining the trusts would have been a violation of applicable state law, and there was no basis for combining or commingling the trusts under federal estate tax law.

Furthermore, the court determined that the loan was necessary to pay the estate tax and the terms of the loan were reasonable. The court noted that, if Trust 1 was to sell its illiquid assets, it would have had to do so at a discount, even if it had sold the assets to Trust 2. Although Trust 1 had enough revenue after three years to repay the loan, the court found that the terms of the loan were reasonable because the volatility of oil and gas prices made future income difficult to predict. In addition, the interest rate was not excessive, as it was based on the market rate for a loan with similar characteristics. Finally, in accordance with Reg. §20.2053-1(b)(3), the amount of the interest expense was ascertainable with reasonable certainty.

The loan was a bullet loan that prohibited prepayment. The trustees of Trust 2 could not permit prepayment because it would reduce Trust 2's interest income. Consequently, the court concluded that the estate was entitled to deduct the interest expense.

The Tax Court further held that the estate was not entitled to deduct expenses incurred in preserving and distributing the estate because the expenses were not necessary to the administration of the estate. Trust management fees were also not deductible because they were not, as claimed, compensation for executor services. However, the court found that additional attorney's fees were deductible and were not computed under Rule 155 because the reasonableness of attorney's fees was a legal issue.

Reference: PTE §34,305.15