In the case of Vincent Duncan Estate v. Commissioner, TCM 2011-255, the Revenue Service had issued the Estate a deficiency for Federal estate taxes due in the amount $4,900,760. The Revenue Service had determined that the Estate’s interest expense in the amount of $10,653,826 was not deductible.
In response to the deficiency notice, the Estate filed a timely petition with the Tax Court.
Upon the decedent’s death in 2006, the decedent’s grantor trust (referred to as the “2001 Trust”) became irrevocable. In his will, decedent exercised a power of appointment over the Walter Trust, which had been previously created by his father.
Before the Tax Court, the most important issue was whether the Estate could deduct the interest on the loan as an administration expense under §2053.
In the trial, the Revenue Service argued unsuccessfully as to why the Estate was not entitled to deduct the interest expense. Disallow of the interest had been made by the Revenue Service due to the following three reasons —
Loan was not a bona fide debt,
Loan was not actually and reasonably necessary to the administration of the Estate, and
Amount of the interest expense was not ascertainable with reasonable certainty.
Whether The Loan Was A Bona Fide Debt
An estate administration expense deduction for interest on any indebtedness must be limited to the extent that the indebtedness was contracted bona fide and for adequate and full consideration in money or money’s worth. §2053(c)(1)(A).
One argument of the Revenue Service was that the loan was not bona fide, based upon an analysis of fifteen factors collectively taken from prior cases. Estate of Rosen v. Commissioner, TCM 2006-115; Estate of Graegin v. Commissioner, TCM 1988-477.
Factors taken from Estate of Rosen were irrelevant to the case, because they were used to decide whether a purported loan should be classified as equity, rather than debt. The loan could not have been equity, even if it was not bona fide.
While the factors taken from Estate of Graegin provided helpful guidance, they were not exclusive, and no single factor was determinative.
Instead, the factors were simply objective criteria helpful to the Court in analyzing all relevant facts and circumstances. The ultimate questions were whether there was a genuine intention to create a debt with a reasonable expectation of repayment and whether that intention fit the economic reality of creating a debtor-creditor relationship. Litton Business Systems, Inc. v. Commissioner, 61 TC 367, (1973).
From the inception, the Revenue Service maintained that there was no objective indication that the Walter Trust intended to create a genuine
debt and that the 2001 Trust intended to repay the loan.
In addition, the Revenue Service argued that the loan had no economic consequence, because the borrower and creditor trusts were identical and had the same trustees and beneficiaries.
To the detriment of the Estate, the Revenue Service viewed the two trusts as a single trust, with the co-trustees free to shuffle money between these “trusts” as they pleased. The Revenue Service argued that the Walter Trust had no reason to demand repayment, because the financial detriment to it would have been offset by the gain to the 2001 Trust. The Revenue Service’s arguments failed, because they ignored Federal tax law and State law.
Both trustees were compelled to direct the 2001 Trust to repay the Walter Trust, because Illinois State law required a trustee of two distinct trusts to maintain the trusts’ individuality.
For example, a trustee could not commingle two trusts’ assets, even when the trusts’ beneficiaries were identical:
“‘That the trustees were or are the same, or that the corpus of each fund finally is to be paid to the same person, can make no difference. Each trust must stand alone, otherwise losses legitimately to be borne, with corresponding loss of income by one, could be imposed in part upon the other.’”
Thus, the co-trustees could not simply ignore the 2001 Trust’s loan obligations, because nonpayment of the loan would have improperly imposed a loss on the Walter Trust, and thereby, effectively shifted assets to the 2001 Trust.
Furthermore, there was no basis in Federal tax law for treating the 2001 Trust and the Walter Trust as a single trust. The only authorities that allowed consolidation of multiple trusts are located in the income tax statute and a regulation addressing trusts with the same or substantially the same grantor. Regs. §1.641(a)-0(c). Neither the statute nor the regulation was applicable, since this was an estate tax case and the trusts did not share a common grantor.
Whether The Loan Was Actually And Reasonably Necessary
Deductible administration expenses must be limited to those expenses which were actually and necessarily incurred in the administration of an estate. Estate of Todd v. Commissioner, 57 TC 288, (1971).
On this point, the Revenue Service argued that the loan was not actually and reasonably necessary, because (1) the 2001 Trust could have sold illiquid assets to the Walter Trust, and (2) the terms of the loan were unreasonable.
Whether the Estate Could Have Met Its Obligations By Selling Illiquid Assets to the Walter Trust
Expenses incurred to prevent financial loss resulting from a forced sale of an estate’s assets to pay estate taxes are deductible administration expenses. Estate of Graegin v. Commissioner, TCM 1988-477; Estate of Todd v. Commissioner, 57 TC 288, (1971).
The Estate claimed it needed to borrow money, because it could not have satisfied its obligations without selling illiquid assets at reduced prices. The Estate estimated its Federal estate tax liability to have been $11.1 million but had liquid assets of only $5.2 million at the time the loan was made.
The Revenue Service did not contest that the Estate had insufficient liquid assets and that a forced sale of illiquid assets to a third party would have required a discount.
Instead, the Revenue Service argued that the 2001 Trust did not need to borrow money, because it could have sold assets to the Walter Trust at full fair market value. The Revenue Service argued that where the beneficiary of an estate was also the majority partner of a partnership owned by the estate, the Court found in Estate of Black v. Commissioner, 133 TC 340, (2009), that a loan from the estate to the partnership unnecessary, because the estate could have redeemed its illiquid partnership interest in exchange for marketable securities held by the partnership.
In that decision, Mrs. Black’s estate had borrowed from the family limited partnership that it substantially owned. The income and distribution history of the partnership indicated that future distributions would be insufficient to allow the estate to repay the loan. Because the loan could not be repaid without selling stock owned by the partnership (and attributable to the estate’s partnership interest), the Court held the loan was unnecessary.
Since the estate’s beneficiary was also the partnership’s majority partner, the beneficiary was on both sides of the transaction and effectively paid interest to himself. As a result, those payments had no effect on his net worth aside from the net tax savings.
In the Duncan decision, the Court found no such facts. Furthermore, the Revenue Service misinterpreted the holding in Estate of Black. The
Court had not held that the loan was unnecessary, because the estate could have sold stock. The Court held the loan was unnecessary, because the estate would have had to sell the stock under any circumstance. The sale of the stock was inevitable, and the estate, therefore, could not have entered into the loan for the purpose of avoiding that sale.
In addition, the Revenue Service’s conclusion was not correct that the 2001 Trust could have sold assets to the Walter Trust at fair market value. If other prospective purchasers had insisted on a discount, the trustees would have been required to do the same.
Under Illinois State law, the trustees could not have directed the Walter Trust to purchase the 2001 Trust’s illiquid assets at an unreduced price, because they would have improperly shifted the value of the discount from the Walter Trust to the 2001 Trust.
Whether the Terms of the Loan Were Reasonable
The Revenue Service alleged that the loan should have been for a shorter term and had a lower interest rate.
Whether the 15-Year Term Was Necessary
On this point, the Revenue Service acknowledged that the Tax Court had generally declined to second guess the judgments of a fiduciary acting in the best interests of the estate. McKee v. Commissioner, TCM 1996-362; Estate of Sturgis v. Commissioner, TCM 1987-415.
However, the Revenue Service maintained that the Tax Court had not permitted an estate to deduct its interest expenses beyond the first 15.5 months of a 10-year loan, where the Court found the estate could have repaid the loan at that time. Estate of Gilman v. Commissioner, TCM 2004-286.
Within three years after the Estate had entered into the loan, the Revenue Service contended that the Estate had generated cash in excess of $16.4 million that it could have been used to repay the loan.
As a result, the Revenue Service argued that the Estate’s interest deduction should have been limited to three years to reflect the Estate’s reasonable ability to have repaid the loan by the end of that period.
Contrary to the view of the Revenue Service, the Tax Court did not second guess the estate’s co-executors in Estate of Gilman. There, the estate owned stock of a holding company and acquired $143 million in promissory notes in a subsequent tax-free reorganization of the holding company. To pay its Federal estate tax, the estate obtained a 10-year, $38 million loan from a bank. Because the notes the estate held were due approximately 15.5 months later and there was no indication that the notes’ obligors would fail to repay, there was no question that the estate could have fully paid its taxes and administration expenses from the repayment of the notes.
Therefore, the Tax Court held that the estate did not need to borrow funds past the date the notes were to be repaid and limited the estate’s interest expense deduction accordingly.
Unlike the co-executors in Estate of Gilman, the trustees were not reasonably certain that the 2001 Trust would have enough money to fully pay the Estate’s Federal estate tax and administration expenses within three years (the period to which Revenue Service proposed to limit the Estate’s interest expense deduction).
To the contrary, an accountant of a related oil and gas partnership credibly testified that the volatility in the price of oil and gas made future income difficult to predict. Although the Estate may have generated enough cash to repay the loan after three years, the Tax Court refused to use the benefit of hindsight to second guess the judgment of the trustees, when they had acted in the best interest of the Estate.
Whether the Interest Rate Was Excessive
Initially, the Revenue Service acknowledged that the interest rate was less than the prime rate and that the Tax Court had previously approved a loan based on the prime rate. Estate of Graegin v. Commissioner, TCM 1988-477.
Nevertheless, the Revenue Service sought to distinguish this case by arguing that the interest rate in Estate of Graegin had an actual economic consequence to the estate, due to the fact that the corporate lender included shareholders outside the Graegin family.
Also, the Revenue Service suggested that the co-trustees should have used the long-term applicable Federal rate and that their selection of a higher interest rate had no economic consequence, since the Walter Trust’s interest income offset the 2001 Trust’s interest expense.
Lastly, the Revenue Service argued that the loan’s interest rate was not reasonable, because there had not been any negotiations between the two trusts.
In the judgment of the Revenue Service, the co-trustees should have used the long-term applicable Federal rate, because that rate did not represent the 2001 Trust’s cost of borrowing.
Apparently, the Revenue Service was unaware of the fact that interest rates are generally determined according to the debtor’s situation, rather than the creditor’s characteristics.
The long-term applicable Federal rate was inappropriate, because it was based on the yield on Government obligations. §1274(d)(1)(C). The long-term rate, therefore, reflected the Government’s cost of borrowing, which was low because Government obligations were low-risk investments. Using the long-term applicable Federal rate, consequently, would have been unfair to the Walter Trust.
The Tax Court rejected the Revenue Service’s argument that a higher interest rate was economically inconsequential simply, because the argument was premised upon the treatment of the Walter Trust and the 2001 Trust as a single trust. Again, there was no basis in Federal tax law or State law for doing so.
Whether The Amount Of Interest Expense Was Ascertainable With Reasonable Certainty
An item may be deducted even if its exact amount was not known, as long as the amount was ascertainable with reasonable certainty and will, in fact, be paid. Regs. §20.2053-1(b)(3). On the other hand, a deduction for interest expense may not be claimed based upon a vague or uncertain estimate.
In desperation, the Revenue Service maintained that the amount of the interest expense was uncertain, because the 2001 Trust could choose to make an early repayment of the loan. An early repayment would have reduced the total amount of interest. At the same time, the Revenue Service acknowledged that a clause in the note prohibited prepayment. The Revenue Service argued, nonetheless, that because the same trustees and beneficiaries stood on both sides of the transaction, the 2001 Trust’s reduced interest expense cancelled out the Walter Trust’s lost interest income and there was no economic interest to enforce the prepayment prohibition clause.
Disagreeing with the Revenue Service, the Court found prepayment would definitely not occur. As discussed above, the Walter Trust and the 2001 Trust were distinct trusts that were administered separately. If interest rates had increased to the point where the Walter Trust would benefit from early repayment, the trustees would not have directed an early repayment, because this would have harmed the 2001 Trust. The 2001 Trust would have been penalized.
Conclusion
To summarize, the Tax Court decided that the loan was a bona fide debt, the interest expense was actually and necessarily incurred in the administration of the estate, and the amount of interest was ascertainable with reasonable certainty. Therefore, the Court held that the Estate was entitled to deduct the interest expense in the amount of $10,653,826 as an estate administration expense under §2053 to decrease the estate tax deficiency.
QSUB ELECTION NEGATED BY UNTIMELY TRANSFER OF STOCK
In the Small Business Job Protection Bill of 1996, P.L. 104-188, Congress decided that “S” shareholders must be allowed to arrange their separate “S” corporations as parent-subsidiary structures, as well as brother-sister structures. This technique to realign the structures of certain “S” and “C” corporations is commonly referred to as entailing a “QSub election.”
A QSub election makes it possible to offset operating losses against operating income in different locations — either domestic or foreign operations.
Restructuring of multiple corporations to make a QSub election may enlarge the aggregate basis of a shareholder’s stock in a newly created parent corporation for purposes of permitting losses to flow through without any limitations.
Netting of capital gains and losses plus §1231 gains and losses at the corporate level may achieve better results than if the same gains and losses had to flow through to the shareholder and be netted at the shareholder level. This is especially true in view of the limitations imposed on the passing of losses to shareholders.
In a QSub election, an electing “S” parent corporation makes an election to treat either an “S” or “C” subsidiary corporation as a qualified subchapter “S” subsidiary — “QSub.”
To be eligible to make a QSub election, the subsidiary corporation of the “S” parent corporation must be wholly-owned — all of the stock of subsidiary corporation must be owned by the “S” parent corporation. In addition, the wholly-owned subsidiary must be a domestic corporation.
In Presidio Advisors, LLC v. United States, (2011), Court of Federal Claims, the Taxpayers contended that PCC was a QSub of Prevad, entitling Prevad to treat PCC’s assets as its own, as of the effective date of an alleged QSub election.
Furthermore, the Taxpayers asserted that Prevad assumed PCC’s $11,881,813 basis in the latter’s equipment before that equipment was contributed to Presidio on November 8, 1998.
In its motion for partial summary judgment, the Government argued that Prevad’s election to treat PCC as a QSub was not effective as of November 8, 1998. As a result, PCC’s allegedly stepped-up basis in its equipment did not carry over to Presidio.
At various times during 1998, Presidio was a partnership comprised of John Larson; Robert Pfaff; Norwood Holdings, Inc., a “C” corporation; and Prevad, Inc., an “S” corporation.
At the beginning of 1998, Larson and Pfaff each held a fifty percent interest in Prevad through their respective grantor trusts.
Sometime during 1998, Norwood Holdings, Inc. purchased a thirty percent interest and, at approximately the same time, Larson and Pfaff transferred their partnership interests to Prevad.
On May 15, 1998, John Larson, Robert Pfaff, and Helminvest Resources, Inc., a foreign tax-exempt corporation, formed the Presidio Capital Corporation (PCC).
On June 26, 1998, Helminvest contributed to PCC an option to buy certain telecommunications equipment subject to a $1.5 million nonrecourse debt, as well as approximately $100,000 of Norwegian currency. In the exchange, Helminvest obtained 900 shares of PCC’s stock and PCC assumed the obligation to close a $12 million short sale in U.S. Treasury securities.
As a result of the transaction, Helminvest, realized a gain of $11.7 million.
On June 26, 1998, PCC acquired the option to purchase the telecommunications equipment.
Next, PCC redeemed all the shares held by Helminvest on October 27, 1998. The redemption caused John Larson and Robert Pfaff — through their respective grantor trusts — to become the sole shareholders of PCC.
Three days later, on October 30, 1998, PCC exercised its option to purchase the equipment and paid $250,000, subject to the $1.5 million nonrecourse obligation. Presidio established PCC’s basis in the equipment as equal to PCC’s basis in the option when it was exercised ($10.2 million), plus the cash paid to exercise the option ($250,000), plus the amount of nonrecourse debt assumed by PCC ($1.5 million). The resulted in a total basis of $11,881,813.
Through their grantor trusts, Larson and Pfaff transferred all of PCC’s stock to Prevad on November 6, 1998. On that same day, Prevad transferred its newly-acquired PCC shares to Presidio.
Due to the untimely transfer of stock, Prevad did not own one hundred percent of the stock of PCC on November 6, 1998. On November 8, 1998, PCC transferred the equipment to Prevad, which, on the same day, transferred the equipment to Presidio.
In December 1998, Presidio sold the equipment, recording a loss of $11,416,813. Presidio computed its loss by subtracting a claimed basis of $11,881,813 from the selling price of $465,000.
On January 19, 1999, Prevad filed a Form 966 with the Revenue Service. On Form 966, Prevad elected to treat PCC as a Qsub retroactive to October 31, 1998. Form 966 was signed by the president of Prevad.
On its 1998 federal tax return (Form 1065), filed on August 19, 1999, Presidio reported gross income of $4,166,311. In computing this figure, Presidio deducted $10,644,471 as a loss from the sale of certain equipment. Presidio calculated the loss by subtracting from the amount realized from the sale ($465,000), a claimed basis of $11,881,813, thereby producing a loss of $11,416,813. Presidio used $10,644,471 of that amount to offset gross income and reported the remaining $772,342 as a nondeductible expense.
On its Schedules K-1, Presidio allocated the entire amount of the loss to Larson, Pfaff and Prevad in the amounts of $1.025 million, $1.025 million, and $9.37 million, respectively.
On or about December 29, 2004, the Revenue Service issued Presidio a notice of final partnership administrative adjustment (FPAA) for 1998, which increased Presidio’s gross income by $10.6 million and reduced its nondeductible expenditures by $772,342.
In the ensuring discovery before the Court, it was established that Prevad was not the sole shareholder of PCC as of October 31, 1998. Rather, Instead, the Taxpayers admitted that Prevad did not become the sole shareholder of PCC until November 6, 1998.
Taxpayers, moreover, further admitted that Prevad did not retain its ownership of PCC, but rather, on the same day, transferred its shares in PCC to Presidio. Accordingly, PCC was not held by an “S” corporation for the entire retroactive period in question, and thus, failed to qualify as a QSub.