What’s the best way to create wealth? If I had a definitive answer, you can bet your margarita that I’d be typing this from a beach somewhere.
From where I’m actually typing this — my Annapolis business law office — I see that one of the best ways to create wealth is to build a successful family business. Which leads conveniently into the best way to lose wealth: letting the estate tax tear down that business.
Failure to establish a family business transition plan can strain a family financially almost as much it does emotionally when the owner dies. Unfortunately, the estate tax doesn’t care whether the previous owner was ignorant of succession planning or was going to do it “maybe next year.” It gets paid either way.
Heirs of such businesses can’t avoid paying the estate tax from the previous owner’s death, but that doesn’t mean that they’re out of options.
If you keep up with the blog — come on, two posts per week isn’t Olympian pace — this may sound familiar. We have previously discussed how a high estate tax can sink a business, but today we’re going to talk about a potential lifeboat: Internal Revenue Code section 6166.
Deferral of the estate tax
Internal Revenue Code section 6166 allows a personal representative to defer estate taxes if the interest in a closely held business exceeds 35 percent of the decedent’s adjusted gross estate. For the estate to defer the payment, you must have the following cards to play:
- The decedent must have been a U.S. citizen or resident at death.
- More than 35 percent of the decedent’s adjusted gross estate must be comprised of an interest in a closely held business.
- You must make a timely section 6166 election on the estate tax return.
If the estate satisfies all these elements, the estate tax, including principal and interest, is paid over a 14-year period.
During the first four years, only the interest on the deferred tax must be paid. The interest rate is two percent on the tax attributable to the first $1,360,000 of the decedent’s estate. After five years, the deferred tax and interest are payable in equal annual installments over a 10-year period.
Meeting the 35 percent threshold
This is a great way to delay the inevitable. It gives a business operator the time to either sell or build a path to payments. But you have to start at the beginning. You have to qualify the business.
The 35 percent of the decedent’s adjusted gross estate is calculated by taking the gross estate and subtracting certain deductions such as debts, funeral expenses, administration costs, mortgages and liens. Such deductions are taken into account prior to applying any available charitable and marital estate tax deductions.
Defining a closely held business
Remember, the business has to qualify. It must be an active trade or business engaged in manufacturing, mercantile or service functions. If the business manages passive investments, you must strip out passive assets in order to meet the 35 percent threshold. Moreover, you can’t consider the passive assets to calculate the deferred tax.
Holding companies that own stock in an active trade or business can satisfy the following requirements:
- The active business must have 45 or fewer shareholders or the decedent owned 20 percent or more of the business’ voting stock.
- The holding company’s interest must exceed 35 percent of the decedent’s adjusted gross estate.
If you can meet these requirements, the holding company’s stock is treated as stock in the active business for purposes of section 6166. However, neither the five-year deferral nor the favorable 2 percent interest rate on the deferred tax will be available.
The second exception enables a holding company that conducts an active trade or business to qualify for the deferral benefits and the favorable interest rate if:
- The company owns 20 percent or more of the voting stock of the subsidiary, or the subsidiary has 45 or fewer shareholders.
- 80 percent or more of the assets of the subsidiary are used to carry on an active trade or business.
Acceleration of the deferred tax
Certain actions will accelerate the payment of all unpaid tax. If you make a distribution, sale, exchange, disposition or withdrawal of 50 percent or more of the decedent’s interest in the closely held business after the date of death, the unpaid tax will be accelerated.
If, on the other hand, the business redeems shares to pay for estate tax, funeral expenses and administrative expenses, the redemption will not result in accelerated payment.
If you decide to liquidate certain holdings to conduct business and the assets continue to be used or owned by the business, acceleration of estate taxes will not occur. However, acceleration occurs if the business liquidates assets and distributes the proceeds to the shareholders in order to engage in separate businesses.
Seek outside advice
Although section 6166 is effectively used to postpone estate tax payment, make sure you’re aware of its criticisms and potential pitfalls. The rules for section 6166 are complex, its application ambiguous in certain circumstances and may be unsuitable for actual business structures. When you analyze whether or not to use section 6166, make sure you speak with your tax and legal advisors to determine if this is appropriate.
Good luck and good hunting.
The Fisher Law Office is renowned for its experience in estate planning, probate administration, asset protection, and business development. Annapolis attorney Randall D. Fisher has practiced for over 20 years, maintains the highest peer review rating for ethics (AV Preeminent) by Martindale-Hubbell, and is a sucker for long walks on the fairways.
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