A section of the federal Internal Revenue Code authorizes estate tax deductions for qualifying interests in family‑owned businesses. For the deduction to apply, the value of the interest in the business held by a person at the time of his or her death must exceed 50% of the total value of the person’s adjusted gross estate. This is known as the “50% liquidity test.”
Probably on the basis of creative, but dubious, tax advice, each of the estates of a husband and wife claimed deductions under this provision of over $600,000, based on loans made to a family‑owned corporation. The question thus arose as to whether an “interest” in the business entity includes a loan made to that entity. Only if there was an affirmative answer to this question could the deduction apply. Unfortunately for the two estates, the U.S. Tax Court and then a federal appeals court answered in the negative.
The federal appeals court conceded that, in a very loose sense, a person who loans money to a business has an interest in the business, but only in that he or she looks to the business to repay the debt. When Congress used the words “interest in an entity” in the deduction provision, it meant that the person whose estate is claiming the deduction has an ownership interest in the entity. In the court’s words, “it strains common understanding to say that a person holds an interest in an entity merely because he or she is a creditor of that entity.”