Qualifying Under Internal Revenue Code Section 6166: Post-death Estate Tax Deferral Through Careful Inter Vivos Planning

• Publication year: 2008
• Author: By Alyse Pelavin, Esq.

QUALIFYING UNDER INTERNAL REVENUE CODE SECTION 6166: POST-DEATH ESTATE TAX DEFERRAL THROUGH CAREFUL INTER VIVOS PLANNING

By Alyse Pelavin, Esq.^*

I. INTRODUCTION

Internal Revenue Code section 6166 provides an important estate tax deferral benefit if an interest in a closely held business exceeds 35 percent of a decedent's adjusted gross estate.¹ If an estate qualifies for Section 6166 deferral, the portion of the decedent's estate taxes attributable to that qualifying business interest may be deferred for five years, during which time the estate pays only interest on the deferred tax. After the five-year deferral period, the deferred estate taxes are payable in equal annual installments over a ten (or fewer) year period² at relatively low interest rates.³ For example, in the first quarter of 2008, the estate tax attributable to the first $1,280,000 of the decedent's estate is subject to a 2 percent interest rate, and the interest rate applicable to the remaining portion is 3.15 percent (45 percent of the underpayment rate of 7 percent).⁴ This combined benefit of deferring estate taxes and "borrowing" at low interest rates permits qualifying estates to continue to operate profitable businesses without the need to seek third party financing, request discretionary extensions to pay estate taxes from the IRS, or undertake a forced sale of the closely held business.

Notwithstanding these important benefits, many practitioners do not adequately consider the qualification requirements of Section 6166 during a client's lifetime, instead focusing on these provisions only after the client's death. Unfortunately, when administering an estate, an executor may discover roadblocks to Section 6166 qualification that could have been avoided with prospective inter vivos planning.

This article highlights several issues relating to Section 6166 qualification that an estate planning attorney should consider for any client who owns an interest in a closely held business.⁵

II. SATISFYING THE 35 PERCENT TEST

To qualify for Section 6166 deferral, the decedent's interest in a closely held business must exceed 35 percent of the decedent's adjusted gross estate.⁶ The adjusted gross estate is determined by deducting from the gross estate only those items permitted under Sections 2053 and 2054, namely, funeral expenses, administration expenses, claims against the estate, unpaid mortgages and indebtedness on property, and casualty losses.⁷ The formula used to determine if an estate satisfies this 35 percent threshold raises two important considerations that are not readily apparent.

A. The Adjusted Gross Estate is Determined Prior to the Application of any Charitable or Marital Estate Tax Deduction

For example, assume a decedent dies in 2008 with an estate valued at $15 million, comprised of (i) $500,000 cash that will be used to pay debts and expenses of the estate, (ii) $10 million of additional cash and marketable securities that will pass to a charity, and (iii) a closely held business valued at $4.5 million, 100 percent of which will pass to the decedent's children. The decedent's estate plan provides that taxes are charged against the assets includable in the decedent's taxable estate.

At first glance, this example would appear to be the perfect example of an estate that Section 6166 is intended to benefit. The client executed this estate plan to ensure continuity of family ownership and control of the closely held business. Further, the decedent's entire taxable estate is comprised of a closely held business that will pass to his children. This estate, however, does not qualify for Section 6166 deferral because the 35 percent test is not applied to the taxable estate of $4.5 million (after the deductions for debts, expenses, and the charitable gift). Rather, it is applied to the adjusted gross estate of $14.5 million (after the deductions for debts and expenses, but before the charitable deduction).

The executors will be faced with an estate tax of $1,125,000, but the only assets available in the taxable estate to pay such taxes are illiquid. To pay estate taxes, the executors will be forced to obtain third party financing, request discretionary extensions to pay estate taxes from the IRS, or consider a forced sale of the closely held business.

Careful planning can alleviate these issues. Inter vivos gifts of cash or other non-closely held business assets can increase the relative size of the closely held business as compared to the client's other assets. By making such gifts, the client can be sure that his or her interest in the closely held business comprises over 35 percent of the client's adjusted taxable estate.

For example, if the above-described decedent had made $2 million of charitable gifts more than three years before his death, his gross estate would have been valued at $13 million (and such lifetime gifts presumably would have qualified for a valuable income tax charitable deduction).⁸ Because the closely held business valued at $4.5 million is more than 35 percent of the adjusted gross estate of $12.5 million the decedent's estate would have qualified for Section 6166 deferral, allowing his executors to defer $405,000 of the $1,125,000 in estate taxes.

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B. The Decedent's Interest in the Closely Held Business Need Not Pass to any Particular Beneficiary

The closely held business can pass to a spouse or charity, and the estate may qualify for Section 6166 deferral notwithstanding that no estate tax is directly attributable to the closely held business. Because Section 6166 deferral is based on the adjusted gross estate rather than the taxable estate, Section 6166 can create an apparent windfall if the closely held business is distributed to a charity or spouse. For example, assume that a decedent dies in 2008 with an estate valued at $13 million, comprised, in part, of cash and securities of $5 million. From this amount, $500,000 will be used to pay debts and expenses of the estate, and $4.5 million will pass to the decedent's children. Assume the remainder of the estate is comprised of a closely held business valued at $8 million, all of which will pass to the decedent's spouse. The decedent's estate plan provides that taxes are charged against the assets includable in the decedent's taxable estate, which pass to the children.

In this example, none of the decedent's taxable estate is comprised of the closely held business. Instead, all estate taxes are attributable to the cash and marketable securities passing to the children. Notwithstanding that the executors clearly have sufficient cash and liquid assets to pay the total estate taxes due of $1,125,000, and that none of the estate taxes are attributable to the closely held business, Section 6166 permits the executors to defer $720,000 of the total estate taxes.⁹

Although a client may assume that Section 6166 deferral is available only with respect to the portion of the estate taxes directly attributable to the closely held business, the provisions of Section 6166 do not so provide. Rather, Section 6166 deferral need not be a consideration when deciding which beneficiary will receive the closely held business.

The entire closely held business may pass to a spouse or charity notwithstanding that no estate taxes will be due on account of the inclusion of such property in the decedent's gross estate. The determination of whether an estate qualifies for Section 6166 deferral is irrespective of which beneficiary receives the decedent's interest in a closely held business.¹⁰

III. ACTIVE BUSINESS, RATHER THAN PASSIVE INVESTMENT

For an estate to qualify for Section 6166 deferral, the closely held business owned by the estate must be an active trade or business.¹¹ However...