Deferring Estate Taxes: Considerations for the Business Owner
By Lance Lvovsky, Senior Manager, Tax & Business Services
This article discusses a provision in the tax law that allows for the deferral of estate taxes and is generally applicable to families where proper estate tax planning was not done and a liquidity issue exists. The tax law provision discussed in this article generally applies to entrepreneur owners of closely held and family businesses or real estate investors, where the individual’s largest holdings comprise the business assets or real estate.
In certain circumstances, a succession plan is in place, facilitating ownership of the business to pass from one generation to the next. In other circumstances, succession planning may have been delayed or overlooked, as entrepreneurs are often consumed with running the day-to-day business operations.
If proper planning strategies are not in place when the business owner passes away, the estate may be in the position of not having sufficient cash on hand to pay estate taxes. The absence of a succession plan can create significant stress on the financial resources of an estate and the beneficiaries. The estate tax can quickly erode cash flow, resulting in the personal representative (who is charged with administering the estate and payment of all tax bills) scrambling to find ways to come up with the necessary liquidity. This can quickly diminish wealth created by the business owner, which was intended to pass to the heirs.
Many planning techniques can be utilized to help fund and provide for liquidity to cover estate taxes. These planning techniques may include (but are not limited to) life insurance, certain types of trust structures such as irrevocable life insurance trusts, utilizing limited partnerships together with valuation discounts, sales to intentionally defective grantor trusts, and buy-sell agreements.
Quick Refresher on Estate Taxes
The estate tax is generally due nine months after date of death. The current federal estate tax exemption (2021 tax year) is $11,700,000 with the federal estate tax rate set at 40%. The estate tax exemption is adjusted for inflation. (This provision is set to sunset after December 31, 2025. Unless there is Congressional action, the estimated estate tax exemption after December 31, 2025, will revert back to around $6,000,000.)
Creating liquidity for an estate that largely consists of illiquid assets can be problematic. Recognizing this, there is a provision in the Internal Revenue Code that allows for a deferral of the payment of the estate tax for up to 14 years.
Deferral of Federal Estate Tax
Internal Revenue Code Section 6166 was created to alleviate an estate’s liquidity problems. The following conditions must be met to qualify for the section 6166 election:
- The decedent must have been a U.S. citizen or resident at the time of his or her death.
- The decedent’s business must have been a sole proprietorship or an interest in a partnership, limited liability company, or corporation that meets certain closely held ownership requirements.
- The closely held business must be an active trade or business.
- The value of the closely held business interest must be more than 35% of the decedent’s adjusted gross estate.
When an estate qualifies for this deferral, installment payments may be used to pay the federal estate tax attributable to the decedent’s interest in a closely held business. The estate’s personal representative must make the Section 6166 election on a timely filed estate tax return (Form 706).
How much estate tax qualifies for deferral?
If the above tests are met, the part of the estate tax bill allocable to the qualifying business interest is eligible for deferral. Consider the following illustration:
The decedent, M, has a federal estate tax bill of $10 million. The qualifying business interest is 38% of the total adjusted gross estate. Therefore, 38% of $10 million, or $3,380,000, would qualify for deferral.
If the estate tax deferral is elected, there is an interest charge on the deferred payments, which varies. The interest rate on the first $1.5 million (approximate, adjusted for inflation) is 2%. The interest rate on the excess deferral beyond this amount is 45% of the underpayment rate. (For example: If the underpayment rate is 5%, then the interest rate is 45% x 5%, or 2.25%.) The underpayment rate can fluctuate and is determined on a quarterly basis by the Internal Revenue Service. Generally, in low interest rate environments, the underpayment rate hovers between 3-6%.
The first payment of principal and interest on the deferred portion of estate taxes must be made within five years of the original payment due date, or five years and nine months from the date of death. This provides the estate with additional time to raise sufficient cash to make the first installment payment of the estate tax.
In effect, the total deferral under IRC Section 6166 is 14 years from the original due date of the estate tax return, or 14 years and nine months from date of death.
Executors and others involved in administration of an estate should be aware of the potential pitfalls and traps of the Section 6166 deferral. The rules are complex, and the application of this deferral should be reviewed on a case-by-case basis. The deferral can be lost if certain requirements are not met, putting the executor and the estate in a dilemma. It is important to conduct proper due diligence with your tax advisors to determine if Section 6166 is appropriate based on the specific facts and circumstances of the estate. Furthermore, cash flow analysis should be completed, and a strategy should be incorporated to raise sufficient cash to cover the deferred estate tax payments during the installment cycle.
For more information, contact your Marcum Trust and Estate tax advisor.