trust expense paid by another trust

Survivor's Trust has all the cash. Marital Trust has very little. Therefore, Survivor's Trust pays Marital Trust's share of the estate tax liability, creating a loan. Of course, the payment of the estate tax is not deductible. I think the interest on the loan is also therefore not deductible under basic tracing concepts. Is anyone aware of another line of thought that results in a better outcome? Thanks.

I'm not quite following your reasoning. The fact that the estate tax is not deductible seems to me to be irrelevant to the deduction for interest on a loan to pay that tax. The tracing rules in sec 163 should control. I see the main question being whether or not the interest can be categorized as investment interest ("properly allocable to property held for investment." Said property would have o be the loan to the marital trust.

Slightly off-topic, but be certain of the relative rights of the 2 trusts. Some states have specific rules about how to apportion estate tax, and it's not necessarily pro-rata. If there's a conflict of interest between the beneficiaries of the trusts, you'd want to make sure the proposed transaction is with full disclosure, etc. to prevent professional liability.

Len, I don't understand your response. Marital Trust must pay interest to Survivor's Trust. I would love to classify the interest as investment interest, but what is Marital Trust's investment property that the loan relates to? I also see the tracing rules as controlling, and the borrowed funds were used to pay a non-deductible expense. Hopefully you have an angle that I simply am not seeing.

Jeff, all issues covered, thanks.

I don't understand my answer either. I had it backwards.

Unless you can make this argument:
Marital trust has lots of investments and little cash.
It either can't (because of non-liquidity) or does not want to (because the investments are too good to sell at this time) sell the investments.
It therefore borrows money to pay the estate tax, but that borrowing is an investment expenditure.

1.163-8T(b)

(3) “Investment expenditure” means an expenditure (other than a passive activity expenditure) properly chargeable to capital account with respect to property held for investment (within the meaning of section 163(d)(5)(A)) or an expenditure in connection with the holding of such property.

I don't know whether that's how tracing works. Probably not, but worth checking.

Better to have documentation at origin, but ...Marital Trust owes and has assets it would be inconvenient to sell. Informal arrangement typically is that collateral for loan is those assets. Can't see making a distinction between a loan from a related party rather than a bank.

Len - thanks, interesting approach, and I will look into it.

Dennis - the issue isn't the collateral for the loan. The issue is the treatment of the interest expense. I would be considering this issue if the loan were, instead, from a bank

JAD, I think Dennis2 is making the point that if there is a formal or even informal arrangement that the investments of the marital trust are collateral for the loan, it supports that the interest is investment interest because it is for the holding of investment property.

I think there are helpful parallels in the section 265(a)(2) area. For example, look at Rev Proc 72-18.

3.03

.03 Direct evidence of a purpose to carry tax-exempt obligations exists where tax-exempt obligations are used as collateral for indebtedness. "[O]ne who borrows to buy tax-exempts and one who borrows against tax-exempts already owned are in virtually the same economic position. Section 265 (2 ) makes no distinction between them." Wisconsin Cheeseman v. United States , 338 F. 2d 420, at 422 (1968) .

3.04

.04 In the absence of direct evi­dence linking indebtedness with the purchase or carrying of tax-exempt obligations as illustrated in paragraphs .02 and .03 above, section 265 (2) of the Code will apply only if the totality of facts and circumstances supports a reasonable inference that the purpose to purchase or carry tax-exempt obli­gations exists. Stated alternatively, sec­tion 265 (2) will apply only where the totality of facts and circumstances es­tablishes a "sufficiently direct relation­ship" between the borrowing and the investment in tax-exempt obligations. See Wisconsin Cheeseman , 388 F. 2d 420, at 422. The guidelines set forth in sections 4, 5, and 6 shall be applied to determine whether such a relationship exists.

It's no shoo-in by any means. You'd want to meet the guidelines in section 4. But even there, some hope can be found.

A sufficiently direct relationship be­tween the incurring or continuing of indebtedness and the purchasing or car­rying of tax-exempt obligations will generally exist where indebtedness is in­curred to finance portfolio investment because the choice of whether to fi­nance a new portfolio investment through borrowing or through the liquidation of an existing investment in tax-exempt obligations typically in­volves a purpose either to maximize profit or to maintain a diversified port­folio. This purpose necessarily involves a decision, whether articulated by the taxpayer or not, to incur (or continue) the indebtedness, at least in part, to purchase or carry the existing invest­ment in tax-exempt obligations.

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Still, to me the big problem is the very direct connection of the loan to payment of estate tax.

How direct? Money is fungible. Maybe the trust paid other expenses, too?

Thanks for the ongoing discussion. The use of cash to pay the estate tax is very direct. Marital Trust owes a very substantial amount to Survivor's Trust. It seems clear that interest costs related to the rental of real property is deducted as part of the calculation of net rental income. Interest costs related to administration (payment for attorney, accountant, appraiser) should be deducted on page 1. No debt was incurred to purchase investment assets, but perhaps the argument can be made that the interest related to the payment of estate tax is investment because it was incurred to avoid having to sell investments assets. I think it is a stretch, but for the amount at issue, it is definitely worth a bit of research by me.

I dunno. The way I've seen this work is that estate taxes and expenses are paid by an administrative trust prior to distribution. If Marital Trust chooses to take assets subject to loan, distribution to marital trust is dr assets cr loan payable to administrative trust. Distribution to survivor trust is dr assets dr loan receivable.

Marital Trust is not really paying any of the taxes and expenses, the distribution is reduced to reflect allocated share. Question is really whether funding with encumbered investment assets yields an investment interest expense.

Question is really whether funding with encumbered investment assets yields an investment interest expense.. Nicely stated.

See PLR 9449011, at least as to the IRS position.

This issue, on the Sec 2053 side, is a Graegin issue.

Dennis – Marital Trust was funded at death of first spouse. This is not a situation where the administrative trust is funding subtrusts. I should have made the details more clear.

Jeff – thanks. Graegin and citator on Graegin gives me a path to explore.