Estate Can't Deduct Interest on Loan Used to Pay Estate Taxes

(Parker Tax Publishing May 2017)

The Eleventh Circuit affirmed the Tax Court's holding that an estate was not permitted to take an interest deduction on a loan it used to pay its tax liabilities where it had sufficient liquid assets to pay the taxes. The court also concluded that the Tax Court properly valued the estate by taking into account certain redemption agreements that had not yet been consummated. Estate of Koons v. Comm'r, 2017 PTC 201 (11th Cir. 2017).

Background

John Koons died in March 2005. Koons, his four children, and other family members owned Central Investment Corp. (CIC), which bottled and distributed soft drinks and also sold vending machine items. As the result of litigation and a subsequent settlement in 1997 with PepsiCo, Inc., CIC sold its soft drink and vending machine businesses to PepsiAmericas, Inc. (PAS). CIC received approximately $402 million in the settlement.

Koons intended to invest the proceeds in new businesses by putting the money into another entity, CI LLC. In January 2005, CI LLC obtained the $402 million plus the CIC assets not sold to PAS, which included four operating businesses. CI LLC sold three of these and kept only one, valued at approximately $3.8 million.

Koons' children disagreed with their father's plans for CI LLC and asked that their interests in CI LLC be redeemed after the sale to PAS. Around the time of the sale, CI LLC's operating agreement was amended to provide for a board of managers. The board of managers was permitted to make distributions at its sole discretion. It was required to consult with a board of advisors composed in part of Koons' children. Members were permitted to transfer membership interests only to Koons' children or grandchildren. In late January 2005, CI LLC made a pro rata distribution of $100 million to its members. The Koons children received about $29 million. Pursuant to the terms of their redemption offers, their redemption payments were to be reduced by the distribution amount.

In February 2005, Koons removed his children as beneficiaries of his estate and replaced them with his grandchildren. Later that same month, Koons contributed his 50.5 percent interest in CI LLC to a trust. He restricted his children's control of CI LLC by eliminating its board of advisors. The children were also removed from the list of permitted transferees of membership interests. Limits were imposed on discretionary distributions. In late February, James Koons wrote his father to say that the redemption offer felt punitive. He raised various complaints and made suggestions regarding the operation of the business. While his letter threatened litigation if the board of managers made decisions that were detrimental to the family, it also expressed gratitude for the "exit vehicle" and said that the Koons children would "like to be gone."

Koons died in March 2005. The Koons children's redemption offers closed in April 2005. On the closing of the offers, the trust's interest in CI LLC increased from 50.5 percent to around 71 percent. At this time, most of the estate's assets were in the trust, and the trust's primary asset was its interest CI LLC.

The estate's remaining liquid assets were not enough to pay its estate tax liability. The trustees decided not to use the interest in CI LLC to pay the taxes because they feared that a distribution would hinder the company's plan to invest in operating businesses. Instead, the trustees borrowed approximately $10 million from CI LLC at a 9.5 percent interest rate. Repayment was not due to begin until 2024, and prepayment was not permitted. The projected interest payments would total approximately $71 million. At the time of the loan, CI LLC had over $200 million in liquid assets.

The estate filed its return in June 2006 and claimed a deduction for the approximately $71 million of interest as an administrative expense. The estate reported the market value of the revocable trust's interest in CI LLC at approximately $117 million as of the date of Koons' death. The IRS issued a notice of deficiency for approximately $42 million in estate tax.

The Tax Court agreed with the IRS's computation of the deficiency and with the IRS's valuation of the estate, which did not include a discount for lack of control. The estate appealed the Tax Court's decision to the Eleventh Circuit.

Estate Administration Expenses

Under Code Sec. 2053, an estate can deduct expenses that are actually and necessarily incurred in the administration of the estate. If the estate takes out a loan to pay its debts because it lacks enough liquid assets, the interest payments on the loan are generally deductible. A loan is necessary where an estate would have otherwise been forced to sell its assets at a loss to pay the estate's debts.

In Est. of Black v. Comm'r, 133 T.C. 340 (2009), the Tax Court held that interest payments are not deductible if an estate makes indirect use of its liquid assets by borrowing money from an entity it owns and then using distributions from that entity to repay the loan. In Est. of Black, the decedent contributed stock to a partnership, then after his death, his estate borrowed money from the partnership and claimed an interest deduction. The Tax Court disallowed the deduction because it found that the partnership distributions would be insufficient to repay the loan and that the estate could have ordered a pro rata distribution from the partnership. In either case, the estate would have to sell the stock; the only difference with the loan was that it resulted in a tax deduction.

Eleventh Circuit's Opinion

The Eleventh Circuit affirmed the Tax Court on both issues. The court cited Est. of Black for the rule that interest payments are not necessary expenses where:

(1) the entity lending money to the estate has sufficient liquid assets that the estate could use to pay the liability; and

(2) the estate lacks other assets and would eventually need to use the entity's liquid assets to repay the loan.

According to the Eleventh Circuit, the loan to the Koons estate was not a necessary expense. First, the court found that the estate had sufficient funds to pay its taxes. The trust owned around 70 percent of CI LLC, which had over $200 million in liquid assets. The trust could have ordered a pro rata distribution to obtain the funds to pay its taxes. The court rejected the estate's argument that a pro rata distribution would violate its fiduciary duty. The estate said that Koons had a long-term investment philosophy to retain liquid assets for investment purposes, and that a distribution would be to the detriment of this business model. The court found that under Ohio law, a majority interest holder has the right to take actions beneficial to that holder as long as minority holders benefit equally. A pro rata distribution by CI LLC would have benefitted all holders equally, so the trust would not have violated its fiduciary duty by ordering such a distribution to pay the estate taxes.

The court also found that, aside from the revocable trust and its interest in CI LLC, the estate did not have the funds to repay the loan from CI LLC. The estate acknowledged that the loan repayment schedule was designed so that the trust could repay the loan out of distributions from CI LLC. The court determined that distributions from CI LLC would be used to pay the estate taxes regardless of whether the estate ordered a pro rata distribution and paid its tax liability immediately or borrowed the money and then paid it back gradually. It also noted that the same entity would be on both sides of the transaction because CI LLC would be making payments to the trust only to have those payments returned to it in the form of principal and interest payments on the loan. The court concluded that there was no net economic benefit from the loan other than the tax deduction.

The court also did not agree with the estate's argument that the loan would be repaid using regular disbursements rather than an immediate, extraordinary distribution. The estate said that an immediate disbursement would have permanently depleted CI LLC, while the loan only temporary depleted it until a later date when it would be repaid using regular disbursements to the trust. The court found this to be a distinction without a difference, and determined that Est. of Black spoke only in terms of the source of the funds. It did not distinguish between a regular disbursement from liquid assets and an immediate disbursement from the same source of funds.

The estate's argument that the court should have deferred to the executor's business judgment was also rejected. The estate argued that the deduction should have been permitted based on the executor's decision that the loan was in the estate's best interests. The Eleventh Circuit distinguished the Tax Court decisions relied on by the estate because they dealt with an executor's decision between taking out a loan and selling illiquid assets, which did not apply in this case because of CI LLC's liquid assets. The court also rejected as a policy matter the idea that a loan is necessary (and that the interest is therefore deductible) whenever the executor acts in the best interests of the estate. In deciding whether to allow a deduction, a court is not considering the soundness of the executor's decision making, only whether the deduction should be allowed. If courts were required to defer to the executor's business judgment, the court said, then executors would in effect have blanket authority to establish that a deduction was proper with no judicial oversight.

The estate argued that the Tax Court should have discounted the value of the estate because the trust's interest in CI LLC was not a controlling interest at the time of Koons' death and the children's redemptions had not yet occurred. The Eleventh Circuit held that the Tax Court was correct in assuming that the redemptions would occur. Each child had signed a redemption agreement. The court also determined that there was enough testimony at trial to confirm that the children wanted to redeem their interests.

The estate also argued that the Tax Court erred in concluding that a hypothetical buyer of the trust's interest in CI LLC would be permitted to force a distribution of most of the LLC's assets. The Tax Court determined that a buyer of the trust's interest would have a majority interest in CI LLC and could therefore vote to distribute the majority of the LLC's assets. It then used this assumption in arriving at its fair market value of the interest. The estate said that a majority holder has a heightened fiduciary duty to minority interests which prevents it from frustrating the purpose for which the LLC was created. According to the estate, a majority holder must have a legitimate business purpose for its actions, and the inability to demonstrate such a purpose would be a breach of fiduciary duty. Koons' investment philosophy was to use CI LLC's funds to invest in businesses; minority holders, by the estate's reasoning, had a legitimate expectation that the LLC would be run according to Koons' wishes.

The court found that the heightened fiduciary duty under Ohio law is focused on preventing abuses of power at the expense of minority holders. It does not, according to the court, impose a general obligation for majority holders' actions to have a legitimate business purpose. A legitimate business purpose must be demonstrated, the court found, only if the action breaches a fiduciary duty. Where an action benefits all holders equally, it does not violate the fiduciary duty obligation and the majority shareholder is therefore not required to demonstrate a legitimate business purpose.

For a discussion of estate tax deductions for administration expenses, see Parker Tax ¶227,520. For a discussion of the valuation of an estate, see Parker Tax ¶224,701.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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