Many family business owners spend years nurturing their companies with the goal of providing a livelihood for their heirs. But often their estates don’t have enough cash to pay estate taxes and other expenses after they die, which can force the family to sell the business. If you’re concerned that your heirs will face this predicament, ask your financial advisor about Internal Revenue Code Section 6166. It allows a portion of the estate tax to be deferred.
The 35% test
If you’re an owner of a closely held business and a citizen or resident of the United States at the time of your death, your estate can potentially qualify for Sec. 6166 treatment. The test is whether the value of the interest in your business exceeds 35% of your adjusted gross estate, which is calculated by subtracting certain deductions, such as mortgages, funeral expenses, debts and administrative costs from your gross estate.
There are a few rules to consider when applying the 35% test. If you’re a sole proprietorship, only the assets used in the company are considered when valuing the business. And the value of passive assets held by your business can’t be included in the valuation.
If you have multiple companies, you must have owned at least 20% of each to combine the businesses for the 35% test. There’s also a general rule that businesses with more than 45 owners won’t qualify, although there are exceptions.
The nuts and bolts
If your estate qualifies for Sec. 6166 treatment, your heirs can pay the estate tax in two or more (but not exceeding 10) equal installments over 10 years. Plus, they can defer payment of the first tax installment for up to five years beyond the date it would have ordinarily been due. During the deferral period, interest must be paid annually. The first principal installment is due at the same time that the last interest-only payment is due.
A special interest rate of 2% is available on the first $1 million in taxable value, which is adjusted annually for inflation. (For 2013, the deferral amount was $1.43 million.) Interest on any balance of the tax is assessed at 45% of the annual interest rate charged on the underpayment of tax.
Sec. 6166 doesn’t apply to the entire amount owed on the estate. The amount of estate tax that may be paid in installments is the proportional amount attributable to the business’s value as compared to the amount of your adjusted gross estate. The remaining estate tax is due nine months after your death.
Real estate qualifies as long as there’s been active management of the property — that is, if those assets are more than passive real estate investments.
The negatives
To minimize taxes and maximize cash flow, make sure your heirs understand the potential disadvantages of tax deferral under Sec. 6166. First, keep an eye on tax liens. To ensure that installment payments are made, the IRS will place a tax lien on your family business, and your estate will remain open and unresolved during the installment period. The greater the debt, the more likely it will adversely affect the company’s credit and hinder its ability to raise funds.
Nonbusiness interest is another hotspot with the IRS. Deferred payments can’t be used to cover federal estate taxes for such interests. Your estate will need enough cash to pay for administrative expenses and accounting and legal fees for 14 years. It also will need sufficient liquidity to cover cash bequests, state death taxes, additional federal estate taxes, and interest and principal for the deferred estate tax.
If a scheduled payment is missed, the IRS can demand immediate payment of all unpaid taxes. Even if your estate pays the installments on time, there are certain circumstances under which the deferral is lost and the balance due will be accelerated. Two examples of this are:
- The business is sold to someone who isn’t considered a “qualified” heir.
- There is distribution, exchange, withdrawal, or disposition of at least 50% of the decedent’s interest in the business. It’s important to note that there is no acceleration of unpaid tax should the business redeem the decedent’s shares to pay funeral and administrative expenses or estate tax.
Consider life insurance
If you are concerned about your estate’s ability to have the necessary cash flow for the annual payments, life insurance could help relieve your worries. Your beneficiaries pay no income tax on your death benefit proceeds, so the entire cash proceeds are immediately available. In addition, if the policy is owned by an irrevocable life insurance trust (ILIT), the proceeds are exempt from estate tax.
It is important to work with your professional advisor. They can help you compare the costs for paying the premiums with the interest and professional fees associated with an installment note to the IRS.
August 11, 2017
