By Tara Halbert
A Graegin loan is an option for estates that do not have sufficient liquid assets to pay estate taxes and/or administration expenses. This type of loan is often used to avoid a forced sale of a closely-held business or other illiquid asset in an estate. In Estate of Cecil Graegin v. Commissioner, the Tax Court determined that future interest payable on a loan taken to pay administrative expenses incurred “in the collection of assets, payment of debts, and distribution of property to the persons entitled to it” are allowable deductions from the taxable estate. This “Graegin” style loan can be an important technique for not only providing liquidity to pay taxes and expenses owed by the estate, but also by providing a deduction to the taxable estate for the fullamount of interest on the loan, as long as the amount of such interest may be calculated with reasonable certainty and is likely to be repaid. Because the interest must be repaid, the loan is generally made by a related party or entity so that the interest paid stays “in the family”.
Courts have swayed both ways regarding the allowance of an interest deduction by an estate since the Graegincase, and it is important to note that certain criteria must be met for the interest deduction to be upheld. As a preliminary matter, the terms of the loan arrangement must be commercially reasonable and similar to the terms of a loan between unrelated parties. The IRS has not affirmatively concluded that a loan between an estate and a person (i.e., a beneficiary) or an entity closely connected to the estate (i.e., a family limited partnership owned by the decedent and beneficiaries) on its face is problematic, but higher scrutiny will be given to these loans. The loan must apply a market rate of interest, and the terms of the loan must restrict prepayment. The most important consideration is the actual need for liquidity. While the executor is not required to demonstrate that borrowing money was an absolute last resort, an executor must demonstrate that it was a prudent course of action, and that there was a non-tax reason for the loan (i.e., preventing liquidation of a closely-held business to pay estate tax). “Self-inflicted illiquidity” by an estate is not a reason for a loan and subsequent interest deduction.
While a Graeginstyle loan may not work in every estate, it may be a useful tool for estates with significant illiquid assets to both provide the liquidity needed to pay administration expenses and reduce the taxable estate (and estate tax owed) via an interest expense deduction. For more information regarding Graegin loans, please contact Tara Halbert in our Lexington, Ky. office at 859-899-8711.