The estate tax dilemma: protecting the interest expense deduction on estate loans.

• Author: Weber, Neal A.

Should taxpayers borrow money to pay estate taxes? In some cases the answer is "yes," because they will be able to claim a tax deduction for interest and loan costs. Minimizing estate taxes is simply not enough. Taxpayers must also consider how their families will eventually pay the estate tax liability.

Consider a common situation: An estate has as its primary asset a family farm or a closely held business that is an ongoing concern. The decedent's heirs wish to continue the business. In this case, the estate may not have enough cash or other liquid assets on hand to pay the estate tax on the farm or business. Assuming the estate does not wish to liquidate the business to pay the estate tax, the estate has two options: a Sec. 6166 election or a Graegin loan.

Sec. 6166 Election

A Sec. 6166 election allows the deferral of the first payment for five years and nine months from the decedent's date of death. Thereafter, each successive payment will be made annually for the next 10 years until the debt has been paid off. However, this election is essentially a loan from the IRS. Depending upon the estate's financial circumstance, either an IRS lien on the business assets or the procurement of a surety bond by the executor may be required to make this election. A Sec. 6166 election also has other disadvantages.

* This election is restricted to qualified business interests. That is, the decedent must have been the owner of an active business and the decedent's interest in that business must be at least 35% of his or her adjusted gross estate.

* The election can be lost if the estate is delinquent in making its installment payments or the business is sold during the installment term.

Graegin Loans

The Tax Court introduced and approved the concept of borrowing money to pay estate tax in 1988 in Estate of Graegin, T.C. Memo. 1988-477. The courts continue to accept this strategy, and it remains a cost-effective way of reducing the estate tax and providing estate liquidity for the heirs of the decedent.

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 (family limited partnership or irrevocable gift 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...