In the absence of proper planning, the death of an owner of a closely held business may lead to an estate tax liability that can devastate the business, even with the federal estate and gift tax exemption under the 2017 tax legislation. While business owners often desire to keep a family business within the family upon death, failure to plan appropriately can compel surviving family members to engage in a postmortem fire sale of the business. Fortunately, planning for the estate tax is not limited to liquidity planning via buy-sell agreements and insurance. Estates can take advantage of statutory and common law strategies that allow them to defer payment of the estate tax, request an extension or secure liquidity via a loan.
While estate tax is typically due nine months from the date of death, section 6166 of the Internal Revenue Code offers estates the opportunity to defer federal estate tax attributable to a closely held business interest so long as three requirements are met:
If the estate satisfies the above requirements, the estate may pay the estate tax over a period not to exceed 14 years, the first four of which are typically interest only, with the final 10 equal payments of interest and principal. During this period, the estate will also pay a favorable rate of interest on the estate tax deferred.
Section 6166 applies only to an interest in a "closely held" business. Determining whether the decedent's business is closely held depends on a two-part test:
These categories include:
The IRS will consider activities of the decedent, agents, and employees, and the partnership, limited liability company, or corporation to determine whether the activities constitute an active trade or business. A business's use of independent contractors will not disqualify the business as an active trade or business as long as the business is not merely holding investment property. However, the use of an unrelated property management company that performs most of the activities associated with the real estate interests suggests that an active trade or business does not exist.
Executors should consider the following prior to electing under section 6166:
Section 6161 allows the executor of an estate to request an extension of time for the payment of estate taxes for up to 12 months if the estate can show "reasonable cause" and, in cases where the estate can demonstrate "undue hardship," the time for payment can be extended for one year up to 10 consecutive years.
Treasury regulations provide the following examples of what is reasonable cause:
An extension beyond 12 months may be granted upon a demonstration of undue hardship, which requires more than an inconvenience to the estate. A sale of property at a price equal to its current fair market value, where a market exists, is not ordinarily considered as resulting in an undue hardship to the estate. The following examples illustrate cases in which an extension of time may be granted based on undue hardship:
Unlike section 6166, interest paid pursuant to section 6161 is deductible as an expense of the decedent's estate.
Estates that lack the liquidity to pay estate taxes or administrative expenses may be able to take advantage of a "Graegin loan," so named after a much-cited 1988 Tax Court case in which a family sought to avoid the sale of their business following the owner's death. In that case, the court held that the full amount of the projected interest payments on the loan could be deducted from the taxable estate up front. The family was able to both secure the liquidity needed to pay the estate tax via the loan, and reduce the overall taxable value of the estate by deducting the future interest payments up front.
To qualify for this treatment, the estate must demonstrate that:
In the original case, the loan was made to the family by the business itself; such arrangements may invite more scrutiny by the IRS than when a commercial lender is involved and provided the estate makes at least annual payments of interest. When working with a commercial lender, the primary concerns are that the estate truly is illiquid and that the interest rate is fixed and not subject to prepayment.
These are just some of the strategies that business owners and their families can avail themselves of in an effort to protect the business and ensure that the family legacy can be passed down to the next generation. It's critical that business owners at risk of leaving a large estate behind without the liquidity to cover the associated estate tax costs work with their advisors — tax accountants, private bankers and wealth strategists — to devise a plan that anticipates every eventuality and utilizes all the tools available.
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