Category: Deductions & Credits; Estate & Trusts:
Income Tax Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Per your request, I have prepared the following summary of my thoughts and findings on the tax issue we discussed on June 26, 1996 and July 3, 1996. You asked me to spend a limited amount of time (2 hours) to determine whether there may be support for a more taxpayer-favorable position with respect to the following circumstances. Taxpayer operated a family farm. After his death, the taxpayer's estate faced the prospect of having to sell the farm in order to pay estate taxes. To avoid that result, the heirs of the estate borrowed money secured by estate assets. The funds were then injected into the estate to pay the estate taxes. The IRS is now asserting that the interest paid by the heirs is personal interest. IRS claims that interest on loans used to pay taxes is inherently personal. The results of my limited research on this matter are as follows. 1. I found nothing directly on point. 2. Temp. Reg. Section 1.163-9T(b)(2)(A) says that interest on debt used to pay taxes is per se personal interest irrespective of the source of income generating the tax liability. I assume this regulation is what the IRS is relying on. While it is true that interest on debt used to pay taxes is generally deemed to be personal interest, it seems to me that the inherent presumption underlying the per se rule is that the taxes in question are the taxpayer's own taxes. If the taxpayer borrows money to pay someone else's taxes, as in this case, I think the general presumption is shattered, and one must look to the relationship between the parties and all the other surrounding facts and circumstances to determine the character of the interest.Further, there is a conflict as to whether the per se rule of Temp. Reg. Section 1.163-9T(b)(2)(A) is a permissible reading of the statute. In D. Miller, CA-8, 95-2 USTC ¶50,485, 65 F3d 687, the Eight Circuit Court of Appeals held the regulation to be valid. In contrast, there is J.E. Redlark, 106 TC --, No. 2, Dec. 51,104, where the Tax Court held the per se rule to be inconsistent with Section 163(h) and its legislative history. Redlark is appealable to the Ninth Circuit. At the very least, these cases indicate that the courts are willing to analyze the facts and circumstances a little more deeply than the per se rule set forth in the regulations would indicate. I would argue vigorously that the general interest tracing rules of Regulation Section 1.163-8T provide that interest is to be characterized in accordance with the use to which the debt proceeds are put. In this case, I would argue that the debt proceeds were used in effect to acquire the farmland and the interest thereon should be treated consistently with the income or loss flowing from the farming operation. 3. The circumstances of this matter remind me a little of the case in which a donee pays the donor's gift taxes. This strikes me as perhaps a more common occurrence than the factual situation at hand. I wonder if there may be some cases on point in this area in which the donee had to borrow to pay the gift tax. I was unable to find anything given the limited scope of my work; however, I think additional research time in this area might be fruitful. 4. Notice 89-35, 1989-1 CB 675, deals with the issue of interest on debt financed purchases of (or capital contributions to) so-called pass-through entities (S corporations and partnerships). For interest tracing purposes, such debt is viewed as if the purchaser/contributor had purchased his proportionate share of each asset of the pass-through entity. Notice 89-35 does not address estates; however, I would argue that an estate in this context is very similar to a partnership. Normally, one does not purchase an interest in an estate nor does one normally contribute capital to an estate, but I would argue that the reasoning that led the Service to the conclusions with respect to partnerships and S corporations lead to the same conclusions with respect to estates. |
