Estate Says It Lacked Liquidity To Pay Taxes Without Loans

As appeared in “Tax Notes Today Federal,” April 16, 2023, by Erin McManus.

The estate of a widow of a regional bank founder is challenging a $5.47 million estate tax deficiency arising from alleged additional unreported lifetime gifts and understated valuations, and from disallowed interest on loans to pay expenses.

Carolyn Wells’s estate argues in its first amended petition in Estate of Wells v. Commissioner, filed March 24, that it needed immediately available funds to pay both administration expenses and taxes, making the interest on the loans a necessary expense.

Thomas Wells Jr., Carolyn’s husband, acquired and consolidated Chicago area banks into First American Bank, which has branches in Illinois, Wisconsin, and Florida.

Following her husband’s death, Wells became the beneficiary of her husband’s residuary trust, which held 89,596 units of Greenbay Investments LP — the entity that likely holds the family’s interest in the banking business.

Wells also held a direct interest in 8,102 units of Greenbay and established in 1988 the Carolyn C. Wells Trust. In accordance with her will, all of her property was distributed to the trust.

The estate says the units were valued at $472.47 per unit when Wells made gifts of the units in 2018, before her death. Using the alternate valuation date six months after death, the units transferred after her death were valued at $504.51, according to the estate.

The estate reported a value of $45.2 million on the units held in the residuary trust, which the IRS valued at $53.6 million. The additional units were valued at $8.74 million by Wells’s trust and $8.9 million by the IRS.

Loans to Pay Tax

The closely held units are arguably illiquid. Taking out loans to pay the estate taxes would be both a more desirable and more efficient method to obtain cash than selling part or all of the company to an outsider.

The estate had nine months to pay the tax after the date of death and not enough cash to make the payment. Nick Bertha, president of Fieldpoint Private Trust, told Tax Notes that the Wells situation is a classic use of a Graegin loan.

In Estate of Graegin v. Commissioner, T.C. Memo. 1988-477, the Tax Court found that a loan was necessary for the estate to pay estate taxes and avoid a forced sale.

Unless an estate can borrow money, it will have no option but to attempt to sell some or all of the illiquid assets. That can have a significant downside in the form of a forced sale at a steep discount, and the likely disenfranchisement of the remaining family members, Bertha said.

“Over IRS objection, the court allowed the estate to not only deduct the interest payable over the life of the loan from the estate tax due, but to do so upfront and without discount. Not only did this create the liquidity to pay the estate tax due, but at the same time significantly reduced the amount that was, in fact, due,” Bertha said.

In Graegin, the IRS argued that the loan from the company wasn’t a true loan because the borrower (estate) and the lender (family corporation) were both controlled by Graegin’s son.

The Graegin court concluded that the interest expense was “actually and necessarily incurred” under reg. section 20.2053-3(a) to avoid a forced sale.

“Needless to say, the IRS was displeased. The issue has been litigated many times in the over 30 years since that decision, and some criteria have evolved for a loan of this variety to successfully withstand scrutiny,” Bertha said.

Bertha outlined the criteria as follows:

  • The estate must have a bona fide need for the loan versus an artificially constructed one (read: one structured by imaginative estate planning).
  • The interest payable must be transparently calculable, at market rates, with repayment expected on enforceable terms and prepayment prohibited.
  • If there is a relationship between the borrower and the lender, versus, for example, between the estate and a third-party commercial lender, the transaction will be subject to a higher level of scrutiny.

Regarding the Wells case, “the Graegin loan, of course, was from the family business to the estate,” Bertha said.

Wells Situation

Assuming the loans were from First American, were at a market rate, and violated no banking laws or regulations, the IRS didn’t provide a reason they weren’t bona fide loans.

The IRS provided no explanation for disallowing the interest deductions other than saying that the loans weren’t necessary in the administration of the estate under section 2053.

The IRS determined that the estate wasn’t entitled to deduct $4.61 million in interest on four promissory notes taken out by two trusts within the estate to obtain funds to pay the estate tax, which the estate computed to be $31.2 million.

Noting that it was difficult to ascertain the overall fact pattern, Bertha said it appears the loans were from the family trusts that held limited partnership interests holding shares of the family business, First American Bank.

Bertha concluded that the dispute appeared to be a standard Graegin case.

Lifetime Gifts

The IRS says Wells made lifetime gifts totaling $8.9 million, not the $8.74 million she reported.

In a related amended petition filed February 13, the estate disputes the IRS’s determination that Wells made gifts totaling $1,683,000 in 2018, before her death.

The estate seeks a declaratory judgment in the second petition that the value of the gifted shares didn’t exceed $1,525,000.

The estate argues that the two gifts of partnership units were properly valued at $500,000 per donee based on a value of $472.47 per unit.

The IRS said in a May 19, 2022, deficiency notice — to which the March 24 petition responds — that if it’s determined that Wells’s 2018 gift didn’t exceed $1 million by $158,000, then the adjusted taxable gifts are as reported on the return.

The estate further alleges that the IRS chose not to issue a Letter 950-G, “30 Day Letter — Straight Deficiency,” because of “the imminent expiration” of the statute of limitations rather than actions or inactions of the estate.

Proposed Regulations

Bertha noted that proposed regulations (REG- 130975-08) under section 2053, released June 24, 2022, are directed in part at Graegin loans and would affect the use of those loans.

According to the IRS and Treasury, limiting the amount deductible to the present value of the amounts paid after an extended post-death period would more accurately reflect 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.

The proposed regulations would require discounting to present value some amounts paid or to be paid in settlement or satisfaction of specified claims and expenses in determining the amount deductible under section 2053.

The full aggregate dollar amount to be paid over the life on the loan is deductible. The regulations propose that the interest payments should be discounted at a market rate because they are paid not immediately but over time, Bertha said.

The proposed regulations would also apply a facts and circumstances test for deductibility, which includes a noninclusive list of 11 factors that “collectively may support a finding,” Bertha said.

Bertha said the factors include many of the criteria established by prior case law, such as:

  • the only practical alternatives to the loan are sale of the assets at significantly below- market prices;
  • the estate doesn’t have liquidity to pay estate tax liabilities; and
  • the beneficiary or family entity is controlled by a beneficiary lender.

Bertha suggests that while the “technique is used by many knowledgeable practitioners, it is not used as frequently as it should be.”

With rising interest rates, the amount of deductible interest will be lower when a discounted present value computation is required, Bertha noted, adding that the technique shouldn’t be used with “eyes wide shut.”


The petitioner in Estate of Wells v. Commissioner, Nos. 16564-22, 16567-22 (T.C. 2023), is represented by Robert A. Bedore of Harris Winick Harris LLP and Walter W. Bell and Brent L. Barringer of Bell & Anderson LLC.