Proposed Regs Address Deductions for Interest and Claims Against an Estate

(Parker Tax Publishing July 2022)

The IRS issued proposed estate tax regulations which would incorporate present-value principles in determining the amount deductible under Code Sec. 2053 for estate expenses, debts, and taxes. The proposed regulations also address the deductibility of interest expenses accruing on taxes and penalties owed by an estate, the deductibility of interest expense accruing on certain loan obligations incurred by an estate, the requirements for substantiating the value of a claim against an estate, and the deductibility of amounts paid under a decedent's personal guarantee. REG-130975-08.

Background

Under Code Sec. 2031(a), the value of a decedent's gross estate includes the value at the time of the decedent's death of all property, real or personal, tangible or intangible, wherever situated. Under Code Sec. 2053(a), the value of a taxable estate is determined by deducting from the value of the gross estate the following amounts that are allowable by the laws of the jurisdiction, whether within or without the United States, under which the estate is being administered: (1) funeral expenses; (2) administration expenses; (3) claims against the estate; and (4) unpaid mortgages on, or any indebtedness in respect of, property where the value of the decedent's interest therein, undiminished by such mortgage or indebtedness, is included in the value of the gross estate.

In 2009, final regulations (2009 Final Regulations) amending the regulations under Code Sec. 2053 were issued in T.D. 9468. The 2009 Final Regulations generally limit the deduction for claims against, and expenses of, an estate to the amount actually paid in settlement or satisfaction of that item. In the 2009 Final Regulations, the IRS stated that future guidance would be provided on the appropriate application of present-value principles in determining amounts deductible under Code Sec. 2053.

On June 28, in REG-130975-08, the IRS issued proposed regulations under Code Sec. 2053. In addition to providing rules for applying present-value principles in determining the amount deductible under Code Sec. 2053, the proposed regulations clarify the rules for deducting interest expense accruing on taxes and penalties owed by an estate, the deductibility of interest expense accruing on certain loan obligations incurred by an estate, the requirements for substantiating the value of a claim against an estate that is deductible under Reg. Sec. 20.2053-4(b) or (c), and the deductibility of amounts paid under a decedent's personal guarantee.

Applying Present-Value Principles to Amounts Deductible under Section 2053

Taxpayers, the IRS, and courts regularly employ present-value principles for valuation and for other income tax and transfer tax purposes. In the preamble to the proposed regulations, the IRS said that limiting the amount deductible by an estate to the present value of the amounts paid after an extended post-death period more accurately reflects the economic realities of the transaction, the true economic cost of that expense or claim, and the amount not passing to the beneficiaries of the estate.

As a result, the proposed regulations would amend the regulations to require the discounting to present value of certain amounts paid or to be paid in settlement or satisfaction of certain claims and expenses in determining the amount deductible under Code Sec. 2053. Specifically, the proposed regulations require calculating the present value of the amount of a deductible claim or expense described in Code Sec. 2053(a) and Reg. Sec. 20.2053-1(a) that is not paid or to be paid on or before the third anniversary of the decedent's date of death, which three-year period the proposed regulations define as the "grace period." Under the proposed regulations, the general formula for calculating the present value of such amounts and the discount rate to be used in the calculation is the applicable federal rate determined under Code Sec. 1274(d) for the month in which the decedent's date of death occurs, compounded annually. The length of time from the decedent's death to the date of payment or expected date of payment will determine whether the federal rate applicable to that amount is the federal mid-term rate or the federal long-term rate. The proposed regulations provide that any reasonable assumptions or methodology in regard to time period measurements may be used in calculating the present value.

In addition, the proposed regulations require a supporting statement to be filed with the Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, showing any calculations of present value. The proposed regulations explain how to calculate present value when the amount of a claim or expense is deductible in advance of the payment of such amount. The proposed regulations provide that the expected date or dates of payment will be used in computing present value and that the expected date or dates of payment will be determined by making a fair and reasonable estimate using all information reasonably available to the taxpayer.

With respect to amounts deductible for multiple claims against an estate relating to a substantially-related matter or a particular asset or to claims totaling not more than $500,000, the proposed regulations provide that the expected date or dates of payment must be identified in a written appraisal document. The proposed regulations also provide that the computation of present value is subject to adjustment if the actual date of payment differs from the estimate used.

Estate Interest Expense Deductions

The proposed regulations address the longstanding issue of the extent to which, and the circumstances under which, interest expense satisfies the requirements for a deductible administration expense under Code Sec. 2053(a)(2). The proposed regulations differentiate between Code Sec. 6166 interest and Code Sec. 6601 interest (non-section 6166 interest) and provide that non-section 6166 interest may accrue on and after the date of a decedent's death on unpaid tax and penalties in connection with an underpayment of tax or a deficiency. In many cases, the IRS said, such interest and the underlying underpayment of tax or deficiency is attributable to the reasonable exercise of an executor's fiduciary duties in administering the estate, as may occur in cases involving legitimate disagreements with the IRS, inadvertent errors, or reasonable reliance on a qualified professional. Thus, the proposed regulations generally provide that such interest is "actually and necessarily incurred" in the administration of the estate and is thus deductible.

However, the IRS noted, there are some circumstances in which such interest expense does not satisfy the "actually and necessarily incurred" requirement in Reg. Sec. 20.2053-3(a), such as when non-section 6166 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 (including careless, reckless, or intentional disregard of rules or regulations) or fraud with intent to evade tax.

The proposed regulations provide that interest expense is deductible only if: (i) 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; (ii) both the interest expense and the loan on which interest expense accrues satisfy the requirement of Reg. Sec. 20.2053-1(b)(2) that they are bona fide in nature; and (iii) 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 (within the meaning of Reg. Sec. 20.2053-3(a)). Finally, the proposed regulations include a nonexclusive list of factors to consider in determining whether interest expense payable pursuant to such a loan obligation of

an estate satisfies the necessary requirements.

Substantiation Requirements for Valuations Performed

The proposed regulations also propose to remove the requirement that valuations of claims must be supported by a "qualified appraisal" performed by a "qualified appraiser" and instead provide new requirements intended to facilitate the appropriate valuation of these claims. The proposed regulations require a written appraisal that adequately reflects the current value of the claim when the Form 706 is being completed. The current value of the claim should take into account post-death events occurring before the time a deduction is claimed as well as those events reasonably anticipated to occur. In addition, the proposed regulations require the written appraisal to consider all relevant facts and elements of value that are known or that can be reasonably anticipated at the time of the appraisal.

Claims Based on Personal Guarantees by Decedent

The proposed regulations provide that a claim founded upon the decedent's agreement to personally guarantee a debt of another is a claim founded on a promise and, accordingly, must satisfy the applicable requirements in Code Sec. 2053(c)(1)(A) and Reg. Sec. 20.2053-4(d)(5). Specifically, the guarantee must have been bona fide and in exchange for adequate and full consideration in money or money's worth. The proposed regulations provide a bright line rule that a decedent's agreement to guarantee a bona fide debt of an entity in which the decedent had control at the time of the guarantee satisfies the requirement that the agreement be in exchange for adequate and full consideration in money or money's worth. Alternatively, the proposed regulations provide that this requirement also is satisfied if, at the time the guarantee is given, the maximum liability of the decedent under the guarantee did not exceed the fair market value of the decedent's interest in the entity. Finally, the proposed regulations provide that the estate's right of contribution or reimbursement will reduce the amount deductible.

For a discussion of estate tax deductions under Code Sec. 2053, see Parker Tax ¶227,530.

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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