• Estate denied deduction for Graegin loan—The estate of John F. Koons III was denied a deduction of $71,419,497 for interest payable on a loan to John’s revocable trust to pay estate taxes (Estate of John F. Koons III, et al. v. Commissioner, T.C. Memo. 2013-94). 

The estate held about $19 million of liquid assets, and John’s revocable trust owned 50.5 percent of Central Investment LLC (CI LLC), which included a 46.94 percent voting interest and a 51.59 percent non-voting interest. The estate tax liability was approximately $21 million, and the revocable trust was subject to a generation-skipping transfer (GST) tax liability of approximately $5 million. On audit, the estate tax and GST tax liability were determined to be $64 million and $20 million, respectively. The deficiency was related to the valuation of the interest in CI LLC owned by the revocable trust and a denial of the deduction for the interest on the loan made to the estate by CI LLC, described below.

To pay the taxes, on Feb. 28, 2006, CI LLC loaned the estate $10.75 million with interest accruing at 9.5 percent. Interest and principal were payable in 14 equal installments, with payments due between 2024 and 2031. At the time, CI LLC owned two operating companies and more than $200 million of liquid assets. CI LLC was the successor, in part, to a family business that bottled and distributed soft drinks and operated a vending machine business.

Prior to John’s death, agreements had been signed in which CI LLC agreed to redeem the interests of John’s children (these redemptions didn’t close until after John’s death). Prior to the redemptions, John’s revocable trust owned a 49.64 percent voting interest. After the redemptions, John’s revocable trust owned a 70.42 percent voting interest. In addition, prior to John’s death, pursuant to a settlement and sale agreement with PepsiAmericas, CI LLC revised its operating documents to include certain restrictions, including requirements to hold at least $40 million in assets and a vote of the majority of the members to permit discretionary distributions.

The Tax Court held that the estate couldn’t deduct the interest payable on the loan. Interest on a so-called “Graegin loan” to pay estate taxes must be “actually and necessarily incurred in the administration of the decedent’s estate” to be deductible under Internal Revenue Code Section 20.2053-3(a). (A Graegin loan is named after the case Estate of Cecil Graegin, T.C. Memo. 1988-477, which held that interest on a loan taken out by an estate to pay its estate taxes because it has insufficient liquid assets may be a deductible expense for estate tax purposes.) The Tax Court held that the loan wasn’t necessary because, at the time of the loan, after the children’s interests were redeemed, the revocable trust held a 70.42 percent voting interest in CI LLC, which allowed it to force distributions to the members of CI LLC. The estate’s assets were not only insufficient to pay the estate tax, but also were insufficient to pay the required principal and interest on the loan, which would have required future distributions from CI LLC as well. Because CI LLC would have needed to eventually make distributions to the revocable trust to pay back the loan, there was no reason to make the loan, rather than an initial distribution to the revocable trust.

The Tax Court also agreed with the Internal Revenue Service’s expert on valuation, applying only a 7.5 percent discount for lack of marketability (the estate had applied a 31.7 percent discount) due to the highly liquid nature of the company.

This case shows that a deduction won’t be allowed if the loan isn’t necessary and reasonable. CI LLC’s loan to the estate for a little over $10 million generated interest payments and a claimed deduction of over $70 million, all while the estate controlled a limited liability company with over $200 million in liquid assets. The estate’s position was too good to be true.


• Ruling applies material participation rule of IRC Section 469 to trust—In Private Letter Ruling 201317010 (Jan. 18, 2013), the IRS ruled on whether the trustees of two trusts materially participated in the relevant activities of the company of which the trusts owned shares, for the purposes of Section 469. Two identical trusts owned shares in Company X (an S corporation), which wholly owned Company Y (a qualified subchapter S subsidiary). One individual served as a trustee of both trusts. In addition, the president of Company Y also served as “special trustee.” As special trustee, he was given the power to make all decisions regarding the voting, sale or retention of stock in Company X and Company Y.

The question was whether the trusts were materially participating in the activities of Company X under Section 469. If not, then research and development expenditures incurred by the company had to be amortized over 10 years under IRC Section 56(b)(2).

IRC Section 469(h) provides that material participation requires participation on a regular, continuous and substantial basis by the taxpayer. However, there’s no other statutory or regulatory guidance on how to apply the rule to a trust. A prior case held that the activities of a trust’s fiduciaries, employees and agents should be considered when determining whether a trust has regular, continuous and substantial participation. But, the ruling held that the proper focus of Section 469 should be solely on the trustee or other fiduciaries.

The trusts had represented that the trustee didn’t have any involvement with the companies. The ruling held the special trustee’s involvement with the company was in his capacity as president of Company Y, not as fiduciary of the trusts. The ruling noted that the special trustee’s time spent regarding the voting, sale or retention of stock would “count” towards material participation, but there was no evidence that his time spent on those functions rose to the level of regular, continuous and substantial.

This ruling may be especially important now for trusts that are trying to ensure material participation in the activities of companies in which they are shareholders, because the new 3.8 percent Medicare surtax under IRC Section 1411 shouldn’t apply to non-passive income.


• 2014 revenue proposals—On April 10, the Obama administration published the Greenbook (otherwise known as General Explanations of the Administration’s Fiscal Year 2014 Revenue Proposals) for fiscal year 2014, which includes several provisions related to estate planning:


Starting in 2018, reverting to estate, gift and GST tax rates and exemptions as they applied in 2009 ($3.5 million estate and GST tax exemption, $1 million gift tax exemption and 45 percent rate);

Requiring a minimum term of 10 years for grantor-retained annuity trusts (GRATs), a remainder interest greater than zero and a prohibition of GRATs with decreasing annuities, effective after the date of enactment;

Treating a sale or gift to a grantor trust as an incomplete transfer for gift and estate tax purposes (such that the trust property would be includible in the estate of the grantor and the gift tax would be due on distributions from the trusts to beneficiaries, rather than on the funding of the trust);

Requiring a donee’s basis to be consistent with the basis of the property reported on the donor’s estate or gift tax return and requiring the donor to report such basis information to the IRS and the donee;

Clarifying that payments made for medical care or tuition must be made directly by the donor to the health care or education institution to qualify for the exclusion from GST tax and that distributions from trusts for these purposes (such as from trusts known as “HEETs”) aren’t excluded from said tax;

Limiting the duration of exemption from the GST tax to a period of 90 years, applying to trusts executed and additions to trusts made after enactment;

Eliminating stretch individual retirement accounts for non-spouse beneficiaries so that they must receive payouts from the IRAs over no more than five years, with an exception for certain minor beneficiaries or beneficiaries with disabilities, applying to IRA participants or owners who die in 2014 or later;

Prohibiting contributions to an IRA or qualified plan to the extent the value of such taxpayer’s IRAs or plans, in the aggregate, exceed the amount necessary to provide the maximum annuity permitted for a tax-qualified defined benefit plan;

Extending the lien under IRC Section 6324 on assets of an estate for which an election for estate tax deferral with respect to business interests under IRC Section 6166 was made, so that the lien lasts for the full period of deferral;

Requiring reporting to the IRS of purchases of an interest in a life insurance contract with a death benefit equal to or exceeding $500,000 and modifying the transfer-for-value rule to ensure that the exceptions to the rule don’t apply to investors purchasing life insurance contracts, beginning in 2014