Sec. 6166 may help ease the sting of estate taxes
Assets such as an illiquid closely-held business can pose unique estate planning challenges. Indeed, even with the gift and estate exemption amount at an inflation-adjusted $11.58 million for 2020, these taxes can continue to be burdensome if a family has a significant amount of wealth tied to a family business.
The good news is that the tax code offers some relief in Internal Revenue Code Section 6166.
Deferring estate tax
For families with substantial closely-held business interests, an election to defer estate taxes under Sec. 6166 can help them 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 to 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 the necessary funds without disrupting business operations.
Be aware that deferral isn’t available for the 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 decedent’s death.
Qualifying for Sec. 6166
Estate tax deferral is available if 1) the deceased was a U.S. citizen or resident who owned a closely held business at the time of his or her death, 2) the value of the deceased’s interest in the business exceeds 35% of his or her adjusted gross estate, and 3) the estate’s executor or other personal representative makes a Sec. 6166 election on a timely filed estate tax return. 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 (and only assets used to conduct that trade or business count for purposes of 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.
In addition to conducting an active trade or business, a closely-held business must be structured as a sole proprietorship, partnership or corporation.
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, the section 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.
Turn to your advisor
As detailed above, there are many variables that go into qualifying for an estate tax deferral under Sec. 6166. We can help you make that determination.