By: Randall A. Denha, J.D., LL.M.
What happens if an estate has assets that it simply cannot sell off to meet estate tax obligations? This will usually be the case with high net worth estates and in Michigan, this could mean that quite a few estates might find themselves facing this problem. There can be an estate tax advantage to an estate borrowing funds, especially from related parties. If the estate is in a high estate tax bracket, it can deduct the interest, and thus save estate taxes. For example, if the estate is solidly in or above the 40% tax bracket, then the estate tax savings are at least 40% of the interest cost.
Can the estate take out a loan to pay off its estate tax?
There are many expenses associated with closing an estate. In addition to court fees and administration expenses, the estate may be liable to creditors. Sometimes, the estate simply does not have enough liquid assets to sell off in order to pay the expenses. And all that may be left are assets that won’t be easy to dispose of — perhaps shares of a closely held corporation that are not marketable.The estate might still have a value above and beyond the applicable estate tax exemption amount (i.e. the estate might be asset rich but cash poor). As such, it might be liable for estate tax based on how rich the estate looks on paper. This is usually the case with many in a family business or those in the real estate industry.
Some estates are trying something out called a Graegin loan. The Graegin loan takes its name from a case called — you guessed it, Estate of Graegin. This type of loan is a loan taken out by the estate for the purposes to pay administration expenses. It’s usually taken out by the estate from a related entity, usually an entity that the estate owes a part of. A Graegin loan may be just the technique you need to prevent unwanted liquidation of estate assets to pay estate taxes and other expenses.
There are many requirements to taking out this type of loan. The one big reason that many estates may consider taking out this type of loan is because if done properly, the estate can take a full up-front deduction on the interest payable under the loan.
A Graegin loan provides an opportunity to use an outside lender instead of the IRS to fund the estate tax loan. The lender can be an external bank or a related party (i.e. family partnership or irrevocable trust) as long as the loan is bona fide. A Graegin loan has the following requirements:
• The estate must be illiquid;
• The loan must be at a fixed rate; and
• The loan must prohibit prepayment.
Most important, a Graegin loan does not have the active business ownership requirements related to other areas of the transfer tax system.
Unlike the interest expense for a Sec. 6166 election, a Graegin loan allows the estate to take a full, nondiscounted deduction on the entire interest expense related to the loan as an administrative expense deduction under Sec. 2053. Sec. 2053 deductions include funeral expenses, administrative expenses, and claims against the estate for which the interest expense would qualify. The estate tax deduction includes all interest owed, not only for the current tax year but for all successive years of the loan. Because the amount of the interest to be paid is ascertainable from the beginning, the full amount of the interest to be paid is permitted as a deduction rather than the discounted present value. This can create a sizable estate tax deduction, thereby dramatically reducing the underlying estate tax liability.
Example: J dies with a $10 million taxable estate in 2015. The top federal estate tax rate is 40%. J’s estate therefore owes $4.0 million in federal estate taxes (assume no state estate tax). J’s estate is illiquid (assets cannot be immediately liquidated), so the executor borrows the money to come up with cash to pay the estate taxes. The executor borrows $2.7 million at 5.5% for 15 years. The note requires a balloon payment of principal and interest at the end of the 15-year period. The accumulated interest payment at the end of 15 years will be $2.2 million.
The full amount of the interest is deductible on J’s federal estate tax return due nine months after the date of death, even though the interest is not actually payable for 15 years. When the interest is deducted, the taxable estate is reduced to $7.8 million, which results in a federal estate tax of $3.12 million. The federal estate tax is reduced from $4.0 million to $3.12 million, a savings of $880,000!
Imagine how much an estate’s tax burden could be reduced if it were able to deduct the full amount of interest on such a loan up front. Here are a few strategies that a Graegin Loan can be used in:
1. Graegin Loan Using Life Insurance
The Graegin case didn’t involve any life insurance. So how does it relate to your life insurance?
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.
2. Graegin Loan For Real Estate Investors
Many in the real estate community have many different entities, including many LLCs. Many of these LLCs contain cash to be used for improvements, maintenance, repairs, etc.. The problem with this strategy is that these assets are exposed to creditors.
Instead, another idea is to create a financial LLC and then contribute the cash to it and use the new financial LLC as the source for the Graegin loan. In today’s tax climate, there is an increased focus on income tax basis planning. Some have argued it may be better to have the real estate included as part of the estate for the step up in basis and instead grow an insurance policy outside the estate within an ILIT (see above) and enhance it with a Graegin loan.
A Closing Word of Caution
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. The terms of the loan must be drafted carefully to avoid undue IRS scrutiny. In order to have a valid Graegin loan, the loan needs to be a real loan, i.e. it needs to be bona fide. There has to be a reasonable expectation that the loan will be repaid (a proper loan contract with real enforceable terms). There should also be no early payment allowed of the loan, as this would help make the interest amount more ascertainable. Finally, the loan needs to be necessary. These loans can’t be taken out randomly. They need to have the purpose of “saving” the estate from having to liquidate its non-marketable assets.