Funding the Estate Tax: Defusing the Liquidity Time Bomb.

• Author: Brown, Nathan R.

Any attempt to discuss the plethora of estate tax reform proposals pending in Congress at a given point in time is likely to prove an exercise in futility. It does, however, seem likely that the era of generous eight-digit estate tax exemptions is coming to a close. The leading reform proposals would reduce the estate tax exemption to $3.5 million and gift tax exemption to $1 million. These reductions would undoubtedly cause more taxpayers to face hefty estate tax bills at death. As planners, we not only assist our clients in reducing their estate tax liability to the greatest extent possible, but also in determining the least disruptive manner in which to satisfy such estate tax liability. In this article, we explore two options for mitigating the impact of the estate tax: deferral and financing arrangements.

Deferring Payment of the Estate Tax with a [section]6166 Election

An executor is generally required to pay a decedent's estate tax liability nine months after the decedent's death. (1) If, however, a significant portion of the estate consists of interests in one or more closely held businesses, the estate may qualify for an election under [section]6166 (2) (a "6166 election"), which defers payment of the estate tax. (3) Section 6166 is intended to provide relief to an estate if the timely payment of estate tax would force the sale of a business enterprise in which the decedent held a large ownership interest. (4)

* General Qualification Requirements --An executor may make a 6166 election if the estate includes a closely held business interest with a value exceeding 35% of the adjusted gross estate (35% AGE test). (5) Multiple closely held business interests may be aggregated for purposes of satisfying the 35% AGE test if each closely held business interest otherwise meets the requirements set forth below. (6)

An interest in a partnership or stock in a corporation will be treated as a closely held business interest for [section]6166 purposes only if 1) the partnership or corporation carries on a trade or business; (7) and 2) either the estate owns 20% or more in value of the capital interests of the partnership or voting stock of the corporation (the 20% ownership test) or the partnership or corporation has fewer than 45 partners or shareholders (the 45 owner test). (8)

Attribution rules, which may reduce the number of owners for purposes of the 45 owner test, apply 1) to treat stock or partnership interests held by a husband and wife as joint tenants or tenants in common as being held by one shareholder or partner; (9) 2) to treat property owned directly or indirectly by a corporation, partnership, estate, or trust as being owned proportionately by its shareholders, partners, or beneficiaries; (10) and 3) to treat a decedent as owning stock and partnership interests held by his siblings, ancestors, and lineal descendants. (11)

Example: Decedent, his spouse, and his three children all own interests in a partnership with 42 other partners--i.e., a total of 47 partners. The partnership would meet the 45 owner test because the family attribution rule treats the decedent, his spouse, and his three children as one partner for purposes of the 45 owner test.

Notably, these attribution rules do not automatically apply for purposes of the 20% ownership test. However, an estate may elect into the attribution rules if necessary to satisfy the 20% ownership test. (12) If an attribution election is made, the estate loses out on certain benefits otherwise available (i.e., no five-year deferral for the first principal installment payment and no 2% interest rate for a portion of the deferred tax (discussed below)).

Example: Decedent's estate and decedent's son each own 10% of the stock of ABC Corporation, and 48 unrelated shareholders own the balance of stock. The stock of ABC Corporation is not readily tradable. ABC Corporation will not meet the 45 owner test, but if the executor of the decedent's estate elects to attribute the stock owned by decedent's son to the estate, the 20% ownership test should be satisfied.

* Effect of 6166 Election--If an executor makes a 6166 election, he or she may defer the payment of estate tax for five years, with the tax then paid in up to 10 equal annual installments beginning on the fifth anniversary of the due date of the estate tax return.

The maximum amount of estate tax that may be deferred is equal to the total estate tax due multiplied by a fraction, the numerator of which is the "closely held business amount" and the denominator of which is the adjusted gross estate. (13) The "closely held business amount" is equal to the aggregate value of the closely held business interests. (14) The adjusted gross estate is equal to the gross estate reduced by allowable deductions under [section][section]2053 and 2054. (15)

Example: Decedent died with an adjusted gross estate of $100 million (after taking into account allowable deductions), consisting of $45 million of closely held business interests and $55 million of marketable securities. Decedent used his lifetime unified gift and estate tax exemption during his life. His estate tax liability is $40 million. $18 million of the tax is eligible for deferral under [section]6166 ($40 million x ($45 million / $100 million)).

In exchange for deferral, the IRS requires the estate to make annual interest payments on the deferred amount. A 2% rate of interest applies to a portion of the deferred tax (the 2% portion) equal to the estate tax rate multiplied by $1 million (adjusted annually for inflation). The interest rate on any amounts in excess of the 2% portion is 45% of the regular underpayment rate--which amounts to 1.35% based on the 3% underpayment rate for the second quarter of 2021. (16) Interest paid under [section]6166 is not deductible for either estate or income tax purposes. (17)

The executor must carefully administer the estate to avoid inadvertently triggering an acceleration of the payment of the entire deferred estate tax. The deferred estate tax may become due and payable if a portion of a closely held business interest is sold or a closely held business distributes funds to the estate that, in the aggregate, exceed 50% of the value of the business interest. (18) Certain redemptions are excluded. (19) In addition, the distribution of a closely held business interest to a revocable trust or another beneficiary of the estate under the terms of the decedent's estate plan should not cause an acceleration event. (20)

The deferred tax may also become due and payable if the executor fails to pay a required installment under [section]6166 (21) or otherwise obtain an extension of time to pay such installment. (22) The executor should be able to cure a default by paying the missed payment within six months of its due date, (23) plus a penalty in the amount of 5% of the payment, multiplied by the number of months (or fractions thereof) after the due date of the payment. (24)

* Holding Company Election--Generally, holding company stock (i.e., stock in a corporation that holds stock of another corporation) that is not directly engaged in a trade or business does not qualify as a closely held business interest for purposes of [section]6166. However, an executor may elect to disregard holding company stock and treat the estate as owning the underlying...