In this case, the Tax Court objected to a Graegin-type loan arrangement between related entities. It is an important decision to review if you are considering such a loan. This case also considered whether certain transfers of FLP interests are includible in a decedent’s estate.
Estate of Black involves the estates of Samuel and Irene Black. Samuel Black owned a large amount of stock in Erie Indemnity Company. In 1993, at the age of 91, Mr. Black, his son and two trusts for Mr. Black’s grandchildren contributed their Erie stock to an FLP in exchange for partnership interests proportionate to the fair market value of the Erie stock each contributed. The transaction was initiated to implement Mr. Black’s buy-and-hold philosophy with respect to the family’s Erie stock, and concerns about his son’s marriage and the possibility that his grandsons would sell the stock when their trusts terminated. At the time the FLP was formed, Mr. Black was in good health and retained approximately $4 million in assets outside the FLP.
Mr. and Mrs. Black died within five months of each other, with Mr. Black dying first. There was a liquidity shortfall to pay estate taxes, so the Executor (who was their son) approached several banks about a loan but he did not like the terms, and the banks did not want FLP interests as collateral. The Executor also approached the Erie Company about a loan, but was turned down. Ultimately, the Blacks’ son, as general partner of the FLP, undertook a secondary offering of approximately one-third of the FLP’s Erie stock. The FLP and Mrs. Black’s estate worked out a loan whereby the FLP would lend the estate approximately $71 million to pay, among other things, estate taxes, a charitable legacy and certain expenses in connection with the secondary offering. The interest was payable in a lump sum on a date more than four years from the date of the loan, and the estate had no right to prepay interest or principal, being patterned on the loan approved in the Graegin case.
The Executor computed the interest on the loan to be $20,296,274 and deducted that amount on Mrs. Black’s estate tax return, in full, as an administration expense of her estate. The IRS assessed large estate tax deficiencies in both estates, denying the deductibility of the interest paid, and arguing for the inclusion in Mr. Black’s estate, under Section 2036, of the Erie stock Mr. Black transferred to the FLP.
The taxpayer won on the 2036 issue, with the Tax Court finding that there was a substantial non-tax reason for forming the FLP and that Mr. Black’s transfer of the stock to the FLP in exchange for the partnership interest was a bona fide sale for adequate and full consideration in money or money’s worth. With respect to the deductibility of the loan interest, the estate argued that the loan was bona fide and similar to the loan blessed by the Tax Court in the Graegin case. The Tax Court ruled for the IRS, holding that the loan was not “necessarily incurred” (and thus not a deductible administration expense) since the FLP could have distributed Erie company stock in redemption of the estate’s partnership interest in an amount that could have covered the estate tax, charitable legacy and other expenses. The Tax Court also was troubled by the fact that the Blacks’ son effectively stood on both sides of the loan transaction, as general partner of the FLP and as Executor of Mrs. Black’s estate.