Par. 3. Section 20.2053-3 is amended by: 1. Redesignating paragraphs (d) and (e) as paragraphs (e) and (f), respectively. 2. Adding a new paragraph (d). 3. Revising newly redesignated paragraph (f). The addition and revision read as follows:
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(d) Interest expense incurred in administering the estate —(1) Interest payable under section 6601 on unpaid tax —(i) Section 6166 interest. As used in paragraph (d)(1) of this section, the phrase “section 6166 interest” means interest payable under section 6601 on unpaid estate tax deferred under section 6166. This includes interest accruing on an installment or other payment under section 6166 during the period of an extension of time for making that payment under section 6161(a)(2)(B). Section 6166 interest is not deductible pursuant to section 2053(c)(1)(D).
(ii) Non-section 6166 interest. As used in paragraph (d)(1) of this section, the phrase “non-section 6166 interest” means interest payable under section 6601 or under state or local law other than section 6166 interest. Non-section 6166 interest that accrues on or after the decedent's date of death on any unpaid tax or penalties may be deductible to the extent permitted by § 20.2053-1 and this section. For purposes of paragraph (d)(1) of this section, penalties include any unpaid additions to tax, additional taxes, and penalties. When non-section 6166 interest accrues on unpaid estate tax deferred under section 6161 or section 6163, the interest expense is actually and necessarily incurred in the administration of the estate for purposes of paragraph (a) of this section because the extension was based on a demonstrated need to defer payment. When non-section 6166 interest accrues on and after the date of a decedent's death on any unpaid tax or penalties in connection with an underpayment of tax or a deficiency, the interest expense generally is actually and necessarily incurred in the administration of the estate for purposes of paragraph (a) of this section.
(iii) Exception. Notwithstanding paragraph (d)(1)(ii) of this section, non-section 6166 interest accruing on unpaid tax and penalties on and after the decedent's date of death, whether in connection with a deferral, underpayment, or deficiency, is not actually and necessarily incurred in the administration of the estate for purposes of paragraph (a) of this section and is not deductible to the extent the interest expense is attributable to an executor's negligence, disregard of applicable rules or regulations (including careless, reckless, or intentional disregard of rules or regulations) as defined in § 1.6662-3(b)(2) of this chapter, or fraud with intent to evade tax. Interest expense is attributable to an executor's negligence, disregard of applicable rules or regulations, or fraud with intent to evade tax to the extent that the underlying deferral, underpayment, or deficiency, is attributable to such conduct by the executor. Similarly, even when the underlying deferral, underpayment, or deficiency is not attributable to such conduct by the executor, the interest expense is attributable to an executor's negligence, disregard of the rules or regulations, or fraud with intent to evade tax to the extent the subsequent accrual of interest is attributable to such conduct by the executor.
(iv) Examples. The following examples illustrate the application of this paragraph (d)(1). In each example, the decedent (D) dies on October 1, Year 1, and the estate tax return is due July 1 of the following calendar year, Year 2. In each example, except as expressly stated, there is no negligence, disregard of applicable rules or regulations, or fraud on the part of the executor.
(A) Example 1. On July 1, Year 2, the executor of D's estate (E) timely files the estate tax return based on values determined in good faith and pays $500,000, which is the estate tax shown on the return. Upon examination, the Internal Revenue Service (IRS) makes an adjustment to the value of an asset includible in the gross estate, resulting in a $25,000 increase in estate tax due. E initially contests the adjustment, but eventually agrees to the assessment of the deficiency in the amount of $25,000. Interest on the deficiency is payable under section 6601 in the amount of $X. E makes a payment in satisfaction of the assessed deficiency and interest. For purposes of paragraph (a) of this section, the interest expense in the amount of $X is considered actually and necessarily incurred in the administration of D's estate, and its deduction reduces the amount of the deficiency.
(B) Example 2. The executor of D's estate (E) files the estate tax return and pays the estate tax shown on the return ($500,000) on July 1 of Year 3, one year after the due date. On August 1, Year 3, the IRS assesses interest on the unpaid tax under section 6601 in the amount of $X, assesses late filing and late payment penalties in accordance with section 6651 in the amount of $Y, and issues a notice and demand for payment of $X and $Y. On August 1, Year 4, E makes payment to the IRS of $Z, which is the total amount due for $X and $Y, as well as interest that accrued on these amounts from August 1, Year 3, to August 1, Year 4, payable under section 6601. The facts establish that E's failure to timely file the return and timely pay the tax and failure to pay the assessed interest and penalties within the period provided in the notice and demand is a result of E's disregard of the rules for filing the return and paying the tax and any assessed penalties. Under the facts in this paragraph (d)(1)(iv)(B), neither the interest payable under section 6601 that accrued on the unpaid tax before notice and demand nor the interest that accrued on the unpaid tax and penalties after notice and demand is an expense that is actually and necessarily incurred in the administration of D's estate for purposes of paragraph (a) of this section.
(C) Example 3. Prior to D's death, the IRS had assessed an income tax deficiency against D for the 2009 tax period in the amount of $75,000, and penalties in the amount of $X. The assessed tax and penalties remained unpaid on D's date of death. On July 1, Year 2, the executor of D's estate (E) timely files the estate tax return and timely pays the estate tax shown on the return to be due. On the same date, E also pays all claims against and liabilities of the estate, except for the assessed income tax deficiency and penalties for the 2009 tax period. Despite E's awareness that the estate had sufficient liquidity and funds to satisfy all estate liabilities, including the 2009 income tax deficiency and penalties, E does not pay the assessed income tax deficiency, penalties, and accrued interest until July 1, Year 4. E's failure to pay the assessed income tax deficiency and penalties for the 2009 tax period is a result of E's disregard of applicable rules or regulations. Even though the underlying income tax deficiency is not attributable to E's negligence, disregard of applicable rules, or fraud with intent to evade tax, the interest that accrued after July 1, Year 2, on the assessed deficiency and penalties is attributable to E's disregard of applicable rules or regulations. Accordingly, the post-July 1, Year 2, interest is not an expense that is actually and necessarily incurred in the administration of D's estate.
(2) Interest expense on certain loan obligations of the estate. Interest on a loan entered into by the estate to facilitate the payment of the estate's tax and other liabilities or the administration of the estate may be deductible depending on all the facts and circumstances. To be a deductible administration expense, interest expense must arise from an instrument or contractual arrangement that constitutes indebtedness under applicable income tax regulations and general principles of Federal tax law. In addition, the interest expense and the loan to which interest expense relates must satisfy the requirement of § 20.2053-1(b)(2) that they are bona fide in nature based on all the facts and circumstances. Further, both the loan to which the interest expense relates and the loan terms must be actually and necessarily incurred in the administration of the decedent's estate and must be essential to the proper settlement of the decedent's estate. See paragraph (a) of this section. If the facts and circumstances establish that the interest expense arises from an instrument or contractual arrangement that constitutes indebtedness under general principles of Federal tax law, factors that collectively may support a finding that the interest expense also satisfies the additional requirements under § 20.2053-1(b)(2) and paragraph (a) of this section include, but are not limited to, the following:
(i) The interest rate on and the terms of the underlying loan (whether between related or unrelated parties), including any prepayment penalty, are reasonable given all the facts and circumstances and comparable to an arms-length loan transaction;
(ii) The underlying loan is entered into by an executor of the decedent's estate acting in the capacity of executor or, if no executor is appointed and acting, the person accountable for satisfying the liabilities of the estate;
(iii) The lender properly includes amounts of paid and/or accrued interest (including original issue discount as determined under sections 1271 through 1275 and the regulations in this part under those sections, such as original issue discount attributable to stated interest that is treated as part of the stated redemption price at maturity because it is not payable at least annually) in gross income for Federal income tax purposes, particularly if the lender is a family member of the decedent, a related entity, or a beneficiary of the decedent's estate or trust (as defined in § 20.2053-1(b)(2)(iii));
(iv) The loan proceeds are used to satisfy estate liabilities that are essential to the proper settlement of the estate, including, but not limited to, the Federal estate tax liability;
(v) The loan term and payment schedule correspond to the estate's anticipated ability to make the payments under, and to satisfy, the loan, and the loan term does not extend beyond what is reasonably necessary;
(vi) The only practical alternatives to the loan are the sale of estate assets at prices that are significantly below-market, the forced liquidation of an entity that conducts an active trade or business, or some similar financially undesirable course of action;
(vii) The underlying loan is entered into when the estate's liquid assets are insufficient to satisfy estate liabilities, the estate does not have control (within the meaning of section 2701(b)(2)) of an entity that has liquid assets sufficient to satisfy estate liabilities, the estate has no power to direct or compel an entity in which it has an interest to sell liquid assets to enable the estate to satisfy its liabilities, and the estate's assets are expected to generate sufficient cash flow or liquidity to make the payments required under the loan;
(viii) The estate's illiquidity does not occur after the decedent's death as a result of the decedent's testamentary estate plan to create illiquidity; similarly, the illiquidity does not occur post-death as a deliberate result of the action or inaction of the executor who then had both knowledge or reason to know of the estate tax liability and a reasonable alternative to that action or inaction that could have avoided or mitigated the illiquidity;
(ix) The lender is not a beneficiary of a substantial portion of the value of the estate, and is not an entity over which such a beneficiary has control (within the meaning of section 2701(b)(2)) or the right to compel or direct the making of the loan;
(x) The lender or lenders are not beneficiaries of the estate whose individual share of liability under the loan is substantially similar to his or her share of the estate; and
(xi) The decedent's estate has no right of recovery of estate tax against, or of contribution from, the person loaning the funds.
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(f) Applicability date. The rules of this section apply to the estates of decedents dying on or after [date of publication of the final rule in the Federal Register ].