One of the ways entrepreneurs create wealth in the United States is by running a successful family business. And one of the ways to lose some of that wealth is for it to be consumed by estate taxes. Failure to plan for the transition of a family business due to the death of an owner or significant shareholder can create a significant stress on cash flow and other financial resources of an estate and the beneficiaries, and, as a result, the closely held business.
Insurance, buy-sell agreements, and gifting strategies are popular planning techniques that can help fund and address potential estate tax concerns. These techniques can help provide liquidity, create a potential market for sale of the business interests, and establish the value of the business for estate tax purposes, or they can shift assets and future appreciation out of the estate, respectively.
However, for those who inherit a business in which there has been a lack of attention to succession planning, there are still various ways to handle payment of the estate tax after the death of an owner, potentially avoiding the need to sell assets to meet estate taxes.
Deferral of the estate tax payment
According to the Internal Revenue Code section 6166, a personal representative may defer payment of estate taxes if the interest in a closely held business exceeds 35 percent of the decedent’s adjusted gross estate.
For the estate to defer the payment of estate taxes, section 6166 spells out elements that must be satisfied:
- The decedent must have been a U.S. citizen or resident at death.
- An interest in a closely held business must comprise more than 35 percent of the decedent’s adjusted gross estate.
- The estate’s personal representative must make the section 6166 election on a Form 706 Federal Estate Tax Return filed in a timely manner.
If the estate satisfies all three elements, the estate tax attributable to the closely held business may be deferred, with principal and interest on the deferred tax paid over a 14-year period. During the first five years following the due date of the return, only the interest on the deferred tax must be paid. Generally, interest will be charged on the balance of the deferred tax at 45% of the rate in effect for underpayments of tax. However, a special 2 percent interest rate applies to a portion of the deferred tax. The portion of the tax to which the special 2 percent rate applies is the lesser of these two figures:
the full portion of the estate tax attributable to the closely held business, or
the product of multiplying the 40% tax rate by the inflation-adjusted taxable value set by code section 6166. Originally $1 million, the amount has been indexed for inflation to $1.59 million for decedents dying in 2021 [see Internal Revenue Procedure 2020-45 (Section 3. 2021 Adjusted Items, .51)]. So for decedents dying in 2021, the estate tax to which the 2 percent estate tax applies would be $636,000.
Beginning five years after the return is due, the deferred tax and interest are payable in equal annual installments over a 10-year period.
Meeting the 35 percent threshold
If you are considering using section 6166 to defer payment of estate taxes, the 35 percent of the decedent’s adjusted gross estate is calculated by taking the gross estate and subtracting deductions allowable under IRC sections 2053 and 2054, such as debts, funeral expenses, administration costs, mortgages, and liens.
However, such deductions are taken into account prior to applying any available charitable and marital estate tax deductions.
For example, consider these two scenarios of decedents who were U.S. citizens and died in 2021, leaving a closely held business, investments, and cash (illustrated in the chart below):
This information is hypothetical and is provided for informational purposes only. It is not intended to represent any specific return, yield, or investment, nor is it indicative of future results.
$13 million: Value of gross estate
$3.6 million: Value of the decedent’s closely held business
$.4 million: Debts and estate expenses (to be satisfied with cash)
$12.6 million: Adjusted gross estate calculated after paying expenses, but before applying the marital deduction
In this case, the $3.6 million closely held business interest represents 28.57 percent of the adjusted gross estate and does not meet the 35 percent threshold. As a result, estate tax deferral benefits would not be available.
$15 million: Value of gross estate
$3.92 million: Value of the decedent’s closely held business
$8 million: Debts and estate expenses (to be satisfied with cash)
$7 million: Adjusted gross estate calculated after paying expenses, but before applying the marital deduction
In this example, the $3.92 million closely held business interest represents 56 percent of the adjusted gross estate. This exceeds the 35 percent threshold and estate tax deferral benefits would be available if the business meets the other two requirements above.
Defining a closely held business
In order for section 6166 to be an available option for you, the closely held business must qualify as an active trade or business engaged in manufacturing, mercantile, or service functions. If the business is comprised of or exists to manage passive investments, you will have to strip out the value of all passive assets — those that are not used to carry out an active trade or business — in order to meet the 35 percent threshold. Moreover, you will not be able to consider the passive assets when calculating the amount of tax that may be deferred.
If your inheritance consists of various real estate holdings, any holdings managed as an active business may qualify, depending on certain factors (as outlined in Revenue Ruling 2006-34, 2006-26 Internal Revenue Bulletin 1172):
- The amount of time the decedent devoted to the trade or business
- Whether an office was maintained from which the activities of the decedent were conducted or coordinated and whether regular office hours were maintained for such purpose
- The extent to which the decedent was actively involved in finding new tenants and negotiating and executing leases
- The extent to which the decedent provided landscaping, grounds care, or other services beyond the furnishing of leased premises
- The extent to which the decedent personally made, arranged for, performed, or supervised repairs and maintenance to the property
- The extent to which the decedent handled tenant repair requests and complaints
If the major asset of a closely held business is stock in other corporations, the business is classified as a holding company that “holds” stock in other corporations.
In such cases, the stock — classified as a passive asset — may prevent the business from meeting the 35 percent threshold. However, section 6166 contains two exceptions:
First, you may make a holding company election if the company it owns stock in, or its subsidiaries, is an active trade or business. To take advantage of the exception, you will need to satisfy the following requirements:
- The active business must have 45 or fewer shareholders or the decedent owned 20 percent or more of the business’ voting stock.
- Voting stock in the active business must be “non-readily-tradable”, meaning no market exists for the security on a stock exchange or over-the-counter market.
- The holding company’s interest must exceed 35 percent of the decedent’s adjusted gross estate.
- The personal representative must make the section 6166(b)(8) election.
If you can meet these requirements, the holding company’s stock is treated as stock in the active business for purposes of section 6166. However, neither the five-year deferral nor the favorable 2 percent interest rate on a portion of the deferred tax will be available.
The second exception enables a holding company that conducts an active trade or business to qualify for the deferral benefits and the favorable interest rate.
To do so, the active holding company must meet these criteria:
- The company must own 20 percent or more of the voting stock of the subsidiary, or the subsidiary must have 45 or fewer shareholders.
- 80 percent or more of the assets of the subsidiary must be used to carry on an active trade or business.
If these two elements are satisfied, then the corporations will be treated as one in the same.
Acceleration of the deferred tax
If you plan on using section 6166, you should be wary of certain actions that will accelerate the payment of all unpaid tax that has been deferred. If you make a distribution, sale, exchange, disposition, or withdrawal of 50 percent or more of the decedent’s interest in the closely held business after the date of death, the payment of all unpaid tax will be accelerated. In addition, the payment of all unpaid tax may be accelerated if you fail to make a payment within six months of the due date.
If, on the other hand, the business redeems shares to pay for estate tax, funeral expenses, and administrative expenses, the redemption will not face an acceleration of the unpaid tax.
If you do decide to liquidate certain holdings in the course of conducting business and the assets continue to be used or owned by the business, acceleration of estate taxes will not occur. However, acceleration will occur if the business liquidates assets and distributes the proceeds to the shareholders to engage in separate businesses.
If you fail to meet the 35 percent threshold
If you do not qualify for section 6166, one option to consider is a loan from a third party lender. Commonly referred to as a Graegin loan, this strategy, which resulted from the Graegin vs. Commissioner U. S. Tax Court case, may permit an estate to borrow money to pay for estate taxes while allowing an immediate deduction of all of the interest due on the loan, thereby reducing the estate tax liability. To be deductible, the interest must be able to be reasonably estimated and it must be certain that the interest will be paid. Typically, a bank or other institution is the lender. In certain circumstances, a loan can be taken from an irrevocable life insurance trust or a related family business; however, those transactions are closely scrutinized. Be sure to consult with your tax and legal advisors before pursuing this option.
Seek outside advice
Although section 6166 has been widely used to deal with a looming estate tax bill, individuals should be aware of its criticisms and potential pitfalls. The rules for section 6166 are complex, its application is ambiguous in certain circumstances, and it may be unsuitable for actual business structures. As a result, when you analyze whether or not to use this strategy, you should make sure that you conduct proper due diligence with your tax and legal advisors to determine if section 6166 is appropriate and cost-efficient or whether you should be considering another strategy.
About the authors: Jennifer Drahos is Associate Director, Wealth Planning, with Abbot Downing, a Wells Fargo business, and Eric Smith is Senior Business Transition Strategist with Wells Fargo Private Bank.