While Section 6166 can be useful, it does have several drawbacks. First, in order to qualify under Section 6166, the business interest must exceed 35% of the business owner’s adjusted gross estate Real estate on Costa Blanca. Second, interest accrues at the rate of 2% on the deferred tax on the first $1, 340, 000 (indexed for inflation) of the business interest in excess of the applicable estate tax exclusion amount. But the interest rate on the deferred tax in excess of that amount bears interest at 45% of the rate applicable for tax underpayments (i. e., the short-term applicable federal rate plus 3% adjusted quarterly). Moreover, the interest paid under IRC Section 6166 does not qualify as an administration expense and is not deductible on either the estate tax return (Form 706) or on the estate’s income tax return (Form 1041). Third, the IRS can place a tax lien on the business until all installment payments are met. This lien may make it difficult for the business to borrow from banks and other lenders. Finally, the IRS can demand immediate payment of all unpaid taxes if the estate misses one scheduled payment, or if there is a sale or exchange of one-half or more of the business.
But Section 303 is not without its disadvantages. First, the stock’s value must exceed 35% of the deceased shareholder’s adjusted gross estate to qualify. Second, where will the cash to redeem the decedent’s stock come from? The corporation may not have excess cash with which to redeem stock. And, if the corporation attempts to accumulate cash to redeem stock, it may be subject to a 15% accumulated earnings tax. IRC Sections 531-537. Finally, like any other redemption, a Section 303 redemption can alter the ownership percentages of the surviving shareholders. Unfortunately, the Tax Court in Estate of Black v Commissioner, 133 T. C. No. 15 (Dec. 18, 2009), struck a blow to Graegin loans. In Black, the estate entered into a Graegin-type loan with an FLP. The Tax Court ruled that the loan was not “necessarily incurred” within the meaning of Treas. Reg. Sec. 20. 2053-3(a) and, therefore, the interest (approximately $20, 296, 274) was not a deductible administration expense under IRC Section 2053(a)(2). The Tax Court found that the FLP could have redeemed the estate’s partnership interest shortly after the taxpayer’s death in order to provide the funds with which to pay the estate tax. This fact rendered the loan unnecessary. The Tax Court also emphasized that the decedent’s son stood on both sides of the loan – as the general partner of the FLP and the executor of the estate. But, it’s not clear from the Tax Court’s ruling whether the outcome would have been different if an independent party had served as the executor.
The problem with the Tax Court’s reasoning in Black is that, had the FLP redeemed the estate’s partnership interest shortly after the deceased partner’s death, the IRS would likely have included in the decedent’s estate any partnership interests gifted during the decedent’s lifetime. In Estate of Erickson v Commissioner, T. C. M. 2007-107, an FLP provided funds for the payment of the deceased partner’s estate tax liabilities. The Tax Court in Erickson reasoned that this was tantamount to making funds available to the decedent resulting in retained enjoyment and, thus, estate tax inclusion under IRC Section 2036(a)(1).
In Graegin v Commissioner, 56 T. C. M. 387 (1988), the Tax Court allowed an estate to deduct (as an administration expense on the estate tax return) the interest on a loan used to pay estate taxes. In Graegin, the estate consisted mostly of closely-held stock and had very little liquidity. So, instead of selling stock; or redeeming stock under IRC Section 303; or paying the estate tax on installments under IRC Section 6166, the estate borrowed the funds to pay estate taxes from a wholly-owned subsidiary of the closely-held corporation.
The note provided that all principal and accrued interest was due in a single balloon payment at the end of the note term, and neither principal nor interest could be prepaid. The Tax Court allowed the estate to deduct the entire balloon interest payment. Of significance is that the amount of interest payable be certain. Therefore, the note cannot permit prepayment of interest or principal. In addition, in order for the balloon interest to be deductible, the estate must show that it had no way of paying estate taxes other than the forced sale of illiquid assets. Otherwise, the interest payment is not a reasonable and necessary administration expense. See PLR 200513028 (Sept. 15, 2004).