Currently, the gift and estate tax exemption amount is high enough ($12.92 million in 2023) that you may not think you need to worry about transfer taxes after you die. But if you have significant wealth in an illiquid closely held business, this may not be the case. One possible solution can be found in Internal Revenue Code Section 6166. This provision enables the estates of family business owners to defer estate taxes and pay them in installments. How does this work and what do you need to do to qualify?
Avoiding Fire Sales
An election to defer estate taxes under Sec. 6166 can help the families of business owners avoid having to sell business assets to pay estate taxes. It allows an estate to pay interest only (at modest rates) for four years and then stretch out estate tax payments over 10 years in equal annual installments. The goal is to enable the estate to pay the taxes out of business earnings or otherwise to buy enough time to raise necessary funds without disrupting business operations.
Deferral isn’t available for the entire estate tax liability. It’s limited to the amount of tax attributable to qualifying closely held business interests. For example, if the value of your interest in a closely held business is equal to 60% of your adjusted gross estate, 60% of the tax would be eligible for deferral. The remaining 40% would be payable within nine months by your heirs after your date of death.
Qualifying for Deferral
Estate tax deferral is available for estates so long as three conditions are met: 1) The deceased was a U.S. citizen or resident who owned a closely held
business at the time of death; 2) the value of the deceased’s interest in the business exceeds 35% of adjusted gross estate, and 3) the estate’s executor or
other personal representative makes a Sec. 6166 election on a timely filed federal estate tax return.
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. Distinguishing between an entity that conducts an active business and one that holds passive investments can be a challenge, particularly when it owns rental real estate.
A closely held business also must be structured as a sole proprietorship, partnership or corporation. (Other structural conditions may apply, particularly with partnerships and corporations, so discuss the matter with your tax advisor.)
Using Special Rules
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, the interests may be combined and treated 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 for interests in partnerships and corporations to qualify.
Applying Sec. 6166 to Real Estate Businesses
When an 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 benefits of Section 6166, the IRS examines multiple factors:
- The amount of time the deceased and the deceased’s employees devote to the business,
- Whether the entity maintains an office with regular business hours,
- The extent to which the deceased or employees provide services (for example, landscaping) beyond furnishing leased premises, and
- The extent to which the deceased or employees arrange, perform, or supervise repairs and maintenance and handle tenant repair requests or
However, the IRS recognizes that real estate businesses often engage third parties to handle day-to-day activities. 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.”
Keeping It in the Family
Taking advantage of an estate tax deferral under Sec. 6166 can help the heirs of business owners keep the company in the family and avoid selling assets
when they least want to do so. To make this option available, work with experienced estate planners and tax experts.
This information is not intended to be a substitute for specific individualized tax or legal advice. Mueller Financial Services and LPL Financial do not provide tax or legal advice & services. Please consult your tax or legal advisor regarding your specific situation.
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