Proposed Changes to Estate Tax Regulations

On June 28, 2022, the Internal Revenue Service (IRS) issued proposed regulations that introduce the use of present-value principles in determining the amount deductible by an estate for funeral expenses, administration expenses, and certain claims against the estate. The proposed regulations also address the deductibility of (i) interest paid on tax and penalties owed by an estate, (ii) interest paid on certain loan obligations incurred by an estate, and (iii) payments made by an estate to satisfy a decedent’s personal guarantee.

Application of Present-Value Principles to Section 2053 Deductions

The proposed regulations require the use of present-value principles in determining the amount of deductible claims or expenses under Section 2053 that are paid after a three-year grace period. Specifically, the amount of a deductible claim or expense that is paid more than three years after the decedent’s date of death is limited to the present value of the claim or expense amount as of the decedent’s date of death.

The present value of each post-grace-period payment is calculated by discounting it from the payment date (or expected payment date) to the decedent’s date of death. The applicable discount rate is the applicable Federal rate determined under IRC Section 1274(d) for the month in which the decedent’s death occurs, compounded annually. The length of time from the decedent’s date of death to the date of payment (or expected date of payment) determines whether the Federal mid-term rate or the Federal long-term rate applies.

The formula for calculating the present value of claims and expenses is found in section 20.2053-1(d)(6)(ii)(A) of the proposed regulations. In the case of multiple post-grace-period payments, the deductible amount is computed by calculating the present value of each payment using the formula and aggregating those amounts. If a claim or expense has multiple payment dates during and after the grace period, the deductible amount is computed by calculating the present value of each separate post-grace-period payment and adding the total of these discounted amounts to the non-discounted amount of any claim or expense with a payment date or expected payment date during the grace period.

Interest Paid on Unpaid Tax and Penalties

Effective for decedents dying after December 31, 1997, IRC Section 2053(c)(1)(D) disallows a deduction “for any interest payable under section 6601 on any unpaid portion of the [Federal estate tax] for the period during which an extension of time for payment of such tax is in effect under section 6166.” The proposed regulations confirm that IRC Section 6166 interest on deferred estate tax accrued after the decedent’s date of death, including interest accrued during an extension, is not a deductible administration expense under Section 2053.

However, in the case of non-Section 6166 interest that accrues on or after the decedent’s date of death on any unpaid tax or penalties, a deduction for such interest may be permitted to the extent the interest is necessarily incurred in the administration of the decedent’s estate. According to the proposed regulations, non-Section 6166 interest incurred in connection with an extension granted under IRC Section 6161 or a deferral elected under IRC Section 6163 is deemed to be necessarily incurred in the administration of the estate (and, thus, is deductible).

If, however, interest accrues on unpaid tax and penalties in connection with an underpayment of tax or deficiency and the underlying underpayment or deficiency is attributable to an executor’s negligence, disregard of the rules or regulations, or fraud with intent to evade tax, the interest expense is not necessarily incurred in the administration of the estate (and, thus, is not deductible).

Interest Paid on Loan Obligations Incurred by an Estate

The proposed regulations provide that interest paid on loan obligations incurred by an estate is deductible only if:

1. The interest accrues pursuant to an instrument or contractual arrangement that constitutes indebtedness under applicable income tax regulations and general principles of Federal tax law;
2. Both the interest expense and the loan are bona fide in nature; and
3. The loan on which interest accrues and the loan’s terms are actually and necessarily incurred in the administration of the decedent’s estate and are essential to the proper settlement of the decedent’s estate.

Factors to consider in determining whether the above three conditions are satisfied include whether or not:

• The terms of the loan (including the interest rate) are reasonable and comparable to an arms-length loan transaction;
• The loan is entered into by the executor of the decedent’s estate;
• The lender properly includes amounts of paid and/or accrued interest in gross income;
• The loan proceeds are used to satisfy the estate’s liabilities;
• The loan term and payment schedule correspond to the estate’s anticipated ability to make payments on the loan;
• The only practical alternatives to the loan are (i) the sale of estate assets at prices that are significantly below-market; (ii) the forced liquidation of an entity that conducts an active trade or business; or (iii) some similar financially undesirable course of action;
• The loan is entered into when the estate’s liquid assets are insufficient to satisfy the estate’s liabilities;
• The estate’s illiquidity occurs after the decedent’s death as a result of the decedent’s estate plan or the action or inaction of the executor;
• The lender is a beneficiary or an entity over which a beneficiary has control; and
• The estate has a right of recovery of estate tax against the person loaning the funds.

According to the preamble to the proposed regulations, these factors suggest that interest paid on a loan incurred by an estate will be deductible if the “loan and its underlying terms are reasonable and comparable to an arms-length loan transaction and correspond to the estate’s ability to satisfy the loan, and the loan obligation is entered into by the executor with a lender who is not a substantial beneficiary of the decedent’s estate (or an entity controlled by such a beneficiary) at a time when there is no viable alternative to obtain the necessary liquid funds to satisfy estate liabilities.”

Deductibility of Amounts Paid Pursuant to a Decedent’s Personal Guarantee

Guarantor agreements often arise in the context of a loan to the guarantor’s closely-held business. According to the proposed regulations, payments made pursuant to a decedent’s obligation as a guarantor of indebtedness are deductible by the decedent’s estate only if the guarantee:

• Represents a personal obligation of the decedent at the time of the decedent’s death;
• Is enforceable against the decedent’s estate; and
• Is bona fide and made in exchange for adequate and full consideration in money or money’s worth.

A decedent’s agreement to guarantee a debt of an entity in which the decedent had an interest at the time of the guarantee is deemed to be made in exchange for adequate and full consideration in money or money’s worth if:

• The decedent had control of the entity at the time of the guarantee; or
• The decedent’s maximum liability, at the time the guarantee was given, did not exceed the fair market value of the decedent’s interest in the entity.

When payments made by an estate pursuant to a decedent’s guarantee satisfy the above requirements for a deductible claim, the amount deductible is limited to the portion of the total claim due from and actually paid by the estate, and must be reduced by the amount recovered, or the amount that could have been recovered, from another party. Further, to avoid double-counting, payments made pursuant to a decedent’s guarantee are deductible only to the extent that the debt for which the guarantee is given has not been treated as a liability in computing the value of the decedent’s gross estate.

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