Many family business owners spend years nurturing their companies with the goal of providing a livelihood for their heirs. But often their estates don’t have enough cash to pay estate taxes and other expenses after they die, which can force the family to sell the business. If your’re concerned that your heirs will face this predicament, ask your Buchbinder executive about Internal Revenue Code Section 6166. It allows a portion of the estate tax to be deferred.
The 35% Test
If you’re an owner of a closely held business and a citizen or resident of the United States at the time of your death, your estate can potentially qualify for Section 6166 treatment. The test is whether the value of the interest in your business exceeds 35% of your adjusted gross estate.
There are a few rules to consider when applying the 35% test. If you’re a sole proprietorship, only the assets used in the company are considered when valuing the business. The value of passive assets held by your business cannot be included in the valuation.
If you have multiple companies, you must have owned at least 20% of each to combine the businesses for the 35% test. There’s also a general rule that businesses with more than 45 owners won’t qualify, although there are exceptions.
The Nuts and Bolts
If your estate qualifies for Section 6166 treatment, your heirs can pay the estate tax in two or more (but not exceeding 10) equal installments over 10 years. Plus, they can defer payment of the first tax installment for up to five years beyond the date it would have ordinarily been due. During the deferral period, interest must be paid annually. The first principal installment is due at the same time that the last interest-only payment is due.
A special interest rate of 2% is available on the first $1 million in taxable value, which is adjusted annually for inflation. (For 2013, the deferral amount is $1.43 million.) Interest on any balance of the tax is assessed at 45% of the annual interest rate charged on the underpayment of tax. With interest rates so low, as of this writing the special 2% rate is actually higher than the rate on the excess, which is currently a mere 1.35%.
Section 6166 does not apply to the entire amount owed on the estate. The amount of estate tax that may be paid in installments is the proportional amount attributable to the business’s value as compared to the amount of your adjusted gross estate. The remaining estate tax is due nine months after your death.
Real estate qualifies as long as there’s been active management of the property — that is, if those assets are more than passive real estate investments.
To minimize taxes and maximize cash flow, make sure your heirs understand the potential disadvantages of tax deferral under Section 6166. First, keep an eye on tax liens. To ensure that installment payments are made, the IRS will place a tax lien on your family business, and your estate will remain open and unresolved during the installment period. The greater the debt, the more likely it will adversely affect the company’s credit and hinder its ability to raise funds.
Nonbusiness interest is another hotspot with the IRS. Deferred payments cannot be used to cover federal estate taxes for such interests. Your estate will need enough cash to pay for administrative expenses, and accounting and legal fees for 14 years. It will also need sufficient liquidity to cover cash bequests, state death taxes, additional federal estate taxes, and interest and principal for the deferred estate tax.
If a scheduled payment is missed, the IRS can demand immediate payment of all unpaid taxes. Even if your estate pays the installments on time, there are certain circumstances under which the deferral is lost and the balance due will be accelerated. For instance, the full balance will become due if the business is sold to someone who is not considered a “qualified” heir.
Work With a Financial Planner
Don’t let your family business perish under the weight of estate taxes after you’re gone. Work with a Buchbinder executive to ensure your family business continues to thrive.