Inflation adjustments published — The Internal Revenue Service published the 2012 inflation adjustments in Revenue Procedure 2011-52. The unified credit against estate tax under Internal Revenue Code Section 2010 was adjusted from $5 million to $5.12 million for 2012. Under the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, the lifetime gift tax exemption and generation-skipping transfer (GST) tax exemption are now tied to the estate tax exemption. Therefore, those exemptions will be $5.12 million, allowing individuals to transfer an additional $120,000 free of gift and GST taxes.

IRS publishes guidance on protective claims under IRC Section 2053 — For decedents dying on or after Oct. 20, 2009, the Treasury Regulations limit deductions under IRC Section 2053 for claims against the estate to only those costs that are ascertainable and actually paid by the time the federal estate tax return, Form 706, is filed. For contingent or contested claims against the estate that aren't finalized and paid by the time the estate tax return is filed, the estate may file a protective claim to preserve the right to later claim an estate tax refund based on a deduction once the claim is eventually paid. These rules, however, don't apply to unpaid claims against an estate that otherwise are deductible (that is, ascertainable, not contingent or contested) and don't exceed $500,000.

Rev. Proc. 2011-48 details the procedure for filing an initial protective claim and the later claim for refund. The estate must file a protective claim within the statute of limitations period under IRC Section 6511(a) for the filing of a claim for a refund, which is three years from the time the return was filed or two years from the time the tax was paid, whichever is later. Then, once the claim is finalized and paid, the estate may notify the IRS and make a claim for a refund based on a deduction for the amount actually paid.

For decedents dying after Jan. 1, 2012, the protective claim is made by either filing a Schedule PC as part of the estate's Form 706 (this schedule is expected to be available with the 2012 Form 706) or by filing Form 843 (which is already available). For decedents dying after Oct. 19, 2009 and before Jan. 1, 2012, the estate makes a protective claim by filing Form 843. A separate schedule or form is required for each protective claim. The estate must describe each claim in sufficient detail so that the IRS has notice of the basis for each claimed deduction. In addition, the estate must describe the reasons and/or contingencies that are delaying actual payment. The revenue procedure provides that ancillary expenses (such as attorneys' fees, court costs, appraisal fees and accounting fees) related to the claim against the estate will be deemed to be included in the protective claim for refund.

The revenue procedure explains that the IRS will acknowledge receipt in written correspondence, but generally not substantively review the initial protective claim. In addition, filing a protective claim shouldn't delay the IRS from reviewing Form 706 or issuing a closing letter.

Once the claim becomes ascertainable and is paid, the estate must notify the IRS within a reasonable period by filing an updated Form 843 for decedents dying after Oct. 19, 2009 and before Jan. 1, 2012 or a Supplemental Form 706 or an updated Form 843 for decedents dying after Jan. 1, 2012. The IRS requires separate notices for each claim. The revenue procedure provides that notice within 90 days of when the claim is actually paid will satisfy the reasonable period requirement. For payments that are made in a series, the 90-day period will begin for the entire aggregate amount on the date of the final payment. Computation of any other deductions, such as the marital and charitable deductions, should be adjusted on these supplemental forms for the additional deduction under IRC Section 2053 relating to the protective claim. Interestingly, the revenue procedure states that “generally, the Service will limit its review of the Form 706 to the deduction under IRC Section 2053 that was the subject of the protective claim.”

Estate entitled to deduct interest on loan obtained to pay estate tax — Vincent J. Duncan, Sr. was a resident of Denver when he died. His son, Vincent J. Duncan, Jr. and Northern Trust, NA (Northern Trust) were appointed co-executors of the estate. Vincent's father, Walter Duncan, had divided a successful oil and gas business among Vincent and his brothers, with each receiving his share of the business in trust. Vincent's trust was for the benefit of Vincent, his wife and his descendants during his life (the Walter trust). At his death, he had the power to appoint the trust's remainder beneficiaries. Vincent Jr. and Northern Trust had been co-trustees of the Walter trust since September 2005.

As part of his estate plan, Vincent established a revocable trust, the Vincent J. Duncan 2001 trust (the 2001 trust). Vincent Jr. and Northern Trust were appointed as co-trustees when Vincent amended the trust in 2004. The trust instrument directed the trustees to pay Vincent's estate's obligations and “death” taxes. After payment of those obligations and taxes, the 2001 trust split into six trusts, each named after one of his six children.

After inheriting one-third of Walter's oil and gas business, Vincent started his own oil and gas business, which was held through a limited partnership (LP). In December 2005, Vincent reorganized his business. The Walter trust contributed $2 million and the LP was restructured as a limited liability company (LLC). After the restructuring, the Walter trust and the 2001 trust both owned interests in the LLC (although the 2001 trust owned its interest through an S corporation).

Vincent died in January 2006. He exercised his power of appointment over the Walter trust in his will and directed the Walter trust's corpus to be distributed pursuant to the 2001 trust, which split the Walter trust into six trusts, each named after one of Vincent's six children. At his death, Vincent owned several residences, interests in other closely held businesses and about $2 million in securities. His estate sold the securities and received a distribution of $3.2 million from the S corporation, but didn't have enough liquid assets to pay the estimated federal estate tax liability of $11.1 million and other obligations.

Vincent Jr. and Northern Trust decided to borrow from the Walter trust to obtain the funds to pay the estate tax. They decided the 2001 trust needed a 15-year term on the loan due to the volatility of oil and gas prices.

In October 2006, Vincent Jr. and Northern Trust, as co-trustees of the Walter trust, loaned approximately $6.5 million to Vincent Jr. and Northern Trust, as co-trustees of the 2001 trust. The note was secured and accrued interest at a rate of 6.7 percent per year (based on a quote from Northern Trust's banking department for a 15-year market rate loan), which compounded annually. The note was due on Oct. 1, 2021 and prohibited the prepayment of interest and principal.

On the estate tax return, the estate claimed a deduction of over $10 million for the interest owed to the Walter trust. The IRS issued a deficiency notice determining that the interest expense wasn't deductible.

The Tax Court disagreed and held in Estate of Vincent J. Duncan, Sr. v. Commissioner, T.C. Memo. 2011-255 (Oct. 31, 2011) that the interest was deductible. Under IRC Section 2053 and the Treasury regulations interpreting it, interest is only deductible if it relates to a loan that was contracted bona fide and for adequate and full consideration and if the expense is actually and necessarily incurred in the administration of the estate.

The IRS argued that the loan wasn't bona fide because the trustees and beneficiaries of both trusts were the same. However, the court explained that the two trusts were distinct under Illinois law and the loan couldn't be ignored because that would improperly shift assets to the 2001 trust. It found that there was a genuine intention to create a debt with a reasonable expectation of payment.

The IRS also argued that the estate could have sold illiquid assets and that the loan terms were unreasonable, concluding that the loan wasn't actually and reasonably necessary. However, the court noted that if the estate sold assets to the Walter trust, its illiquid assets would have been subject to a discount. It also held that the terms were reasonable. Even though the estate ultimately did end up receiving enough cash through its holdings in the businesses to repay the loan, the court refused to use hindsight to second-guess the fiduciaries' decision to borrow from the Walter trust. The court also blessed the use of the 6.7 percent interest rate when the long-term applicable federal rate (AFR) was 5.02 percent, noting that the AFR would have been inappropriate here because it was based on government obligations that are low risk. The IRS had argued that the interest rate was unreasonable because the trustees didn't “negotiate” the rate, but the court held it would be absurd to expect the trustees to try to negotiate between themselves as different fiduciaries.