Even though the current gift and estate tax exemption amounts are high, some families with wealth tied up in a closely held business could be forced to sell assets to meet tax obligations. However, Internal Revenue Code Section 6166 can provide relief. Let's take a look.
An election to defer estate taxes under Sec. 6166 can help some family business owners avoid having to sell business assets to pay estate taxes. Sec. 6166 allows an estate to pay interest only (at modest rates) for four years and then to stretch out estate tax payments over 10 years in equal annual installments. The goal is to enable the estate to pay taxes out of business earnings or otherwise buy enough time to raise the necessary funds without disrupting business operations.
Be aware that deferral isn't available for an entire estate tax liability. Rather, it's limited to the amount of tax attributable to qualifying closely held business interests. For example, if the value of an interest in a closely held business were equal to 60% of the adjusted gross estate, 60% of the tax would be eligible for deferral. The remaining 40% would be payable within nine months after the deceased's date of death.
Estate tax deferral is available if the following three conditions are met:
Typically, the estate is required to provide security for future tax payments by furnishing a bond or allowing a tax lien to be filed against the business or other assets.
To qualify as a "closely held business," an entity must conduct an active trade or business at the time of the deceased's death. Only assets used to conduct that trade or business count toward the 35% threshold. Merely managing investment assets isn't enough.
In addition to conducting an active trade or business, a closely held business must be structured as one of the following:
Several special rules make it easier to satisfy Sec. 6166's requirements. For example, if an estate holds interests in multiple closely held businesses and owns at least 20% of each business, it may combine them and treat them as a single closely held business for purposes of the 35% threshold. In addition, Sec. 6166 treats stock and partnership interests held by certain family members as owned by the deceased. That means the estate can count interests held by the deceased's spouse, siblings, ancestors and lineal descendants toward the 35% and 20% thresholds.
On the other hand, the interests owned by corporations, partnerships, estates and trusts are attributed to the underlying shareholders, partners or beneficiaries. This can make it harder to stay under the 45 partner/shareholder limit.
If your family entity owns rental real estate, the line between active business and passive investment can be blurred. To determine whether an entity is an active business entitled to the estate tax deferral benefits of Section 6166, the IRS examines four factors:
IRS guidance recognizes, however, that real estate businesses often engage third parties to handle day-to-day real estate activities. But using independent contractors doesn't prevent an entity from qualifying as an active trade or business, so long as its activities go beyond merely holding investment property.
Using an estate tax deferral under Sec. 6166 can help you keep a family business in the family without putting unnecessary financial pressure on your survivors. Talk to your tax advisor for details about this strategy.