Estate of Hughes: A Graegin Loan And A Great Result

A Graegin Loan is one obtained by an estate to pay death taxes and administration fees.  Typically, court approval of the transaction is necessary for the loan to be considered necessary for the administration of the estate.  Once that hurdle is cleared, the interest expense is deductible which is of considerable benefit.  Estates that are illiquid or faced with depressed market conditions for its assets are good candidates for the technique.  There are, however, complications that may arise from use of the technique.

In 2000, Mark Hughes, founder of Herbal Life (the “Company”) died testate leaving everything to a trust. The trust, in turn, provided for several specific bequests of Company stock, including one to his son who was also the beneficiary of the remaining trust assets. The gross estate was $300 million and the tax bill was $212 million. The tax clause charged each bequest and the residuary with its pro rata share of the tax bill.  Most of the trust assets were in limited liability companies and the trust could not compel distributions.  The source of the Graegin loan was a family partnership that loaned $50 million to a limited liability company that on-loaned the funds to estate with a slight spread.  Both loans were zero coupon.  The loan to the estate created an interest deduction of $49 million and an estate tax savings of $166 million.

Due to a merger and sale of Company, cash was distributed from the trust based upon a figure of $19.50 per share rather than the fair market value FMV of Company stock in an attempt to strike a balance between the interests of the son and the other recipients of bequests. The Graegin transaction brought with it certain income tax consequences because only the trust (passing to the son) would benefit from the estate tax deduction for administration expenses.  Thus, the California probate court approved estate tax proration based upon market value, not the $19.50 distribution figure.

The Appellate Court reversed stating that the probate statute did not contemplate the consideration of future income tax consequences.  Although the estate tax interest deduction on the return will cause the son to recognize income in future years, future income tax rates and tax brackets are too uncertain.  Although the estate tax savings was $166 million, the income tax cost was $49 million leaving the trust with a $113 million net savings.

Plans that use Graegin Loans should consider the income tax implications.  If the residuary were charged with all of the tax proration litigation may have been avoided.