Take-Away:  When a married couple own a closely held business and they plan to exploit the opportunity to pay federal estate taxes associated with that business in installments over several years, it would be wise for the deceased owner of the business to reconsider the IDGT lifetime sale strategy, and to use a QTIP Trust to hold the business interest. Otherwise the opportunity to pay substantial estate taxes in installments over several years might be lost.

Context: Many of our clients own closely held business interests which will cause federal estate tax problems for them and  for their spouse. Planning for these clients often takes into consideration the ability to pay federal estate taxes associated with that closely held business interest(s) over several years, as opposed to paying the entire federal estate tax liability in 9 months from the deceased owner’s death. But not all closely held business interests will qualify for the opportunity to pay estate taxes in installments over several years, and not all surviving spouses who inherit the closely held business will be able to exploit the opportunity to elect the payment of federal estate taxes associated with the closely held business over an extended period of time permitted by IRC 6166. This opportunity to pay federal estate taxes in installments over several year can also be lost if the owner uses the popular technique of a sale of a business interest to an intentionally defective trust, which exchanges a business interest for an installment promissory note.

6166 Benefit: The key benefit if an election is made under IRC 6166(a)(1) is that the decedent’s estate is entitled to pay federal estate taxes on the closely held business interests in 10 equal installments and defer the initial estate tax payment for 5 years from the required payment date, paying interest only during the 5 year deferral period. In short, the final installment payment can be deferred for a period of 14 years from the original required  payment date.

Law:  Several technical rules must be satisfied before a closely held business can qualify to elect to defer the payment of federal estate taxes associated with that business.

  • Closely Held Business:  (i) The decedent’s interest in a proprietorship, corporation, partnership, or LLC will qualify if there are 45 or fewer partners or other entity owners;  or (ii) the decedent’s gross estate owns 20% or more of the total capital of the business entity, or 20% or more of the voting interest in the entity. Fortunately for this 45 maximum owner limitation, family attribution rules will apply, so that other family business owners who are closely related to the decedent will have their interests in the entity deemed to be owned by the decedent (thus making it easier to satisfy the 45 owner limitation, and also making it easier to meet the minimum 20% capital/voting interest requirement.)
  • 35% Test: To qualify for the IRC 6166 deferral election, the decedent’s closely held business interest must be greater than 35% of the decedent’s adjusted gross estate. This sounds like a  fairly easy threshold, but there are a couple of major limitations to the 35% test. First, the value of the business is determined by removing from its value all passive assets, e.g. stock portfolios, owned by the business. So the temptation by many business owners to accumulate passive investments in the name of their business may come back to haunt them if they expect their estates to qualify for IRC 6166. Second, this is one situation where the IRS will turn the tables and argue for estate valuation discounts if the decedent’s interest in the business was a minority interest, e.g. lack of control or lack of marketability discounts will be applied in determining the businesses’ value. In sum, to determine the value of the decedent’s interest in the closely held business, passive, non-business related assets will be washed out, and valuation discounts will be applied to establish the ultimate business value used to determine if the 35% of the adjusted gross estate ‘test’ is met.  Fortunately several unrelated closely held business interests that were owned by the decedent can be aggregated to pass the 35% test, but each of these unrelated  businesses  must meet the 20% owned capital requirement.
  • Active Business: To be eligible to make a 6166 election, the business interest must be Several factors go into whether a business is active or not, especially real estate, like a real estate holding LLC. Factors include: the time the decedent and the decedent’s agents and/or employees devote to the business; whether an office is maintained with regular business hours; whether the decedent or his/her agents or employees are actively involved in maintaining and expanding the business. These and other factors are outlined by the IRS in Rev. Rul. 2006-34 in its determination if a business is active or passive for 6166 purposes.

Practical Implications If the Goal Is to Preserve 6166 Eligibility:

  1. Accumulating passive investments or other non-business related assets in the name of the business entity is not a good idea when the ultimate goal is to have the business’ value be worth at least 35% of the deceased owner’s estate- passive assets are excluded from the businesses’ value.
  2. If advice given to the business owner is to make lifetime gifts, non-business assets should be considered first to gift, to make it easier to meet the 35% threshold of the owner’s adjusted gross estate.
  3. If multiple smaller business interests are owned, care should be taken to try to maintain the 20% threshold equity ownership  interest in each business entity in order for the estate to be able to aggregate the several business interests in order to reach the 35% of the adjusted gross estate test.
  4. If the client is financing or refinancing the closely held business, cash held in a business that is not needed for the business’ operating expenses will be treated as a passive asset, which will be included in the taxable estate for federal estate tax calculation purposes, but the cash will be disregarded for IRC 6166 eligibility purposes. Similarly, refinance proceeds that are distributed to the owner but not reinvested in the business will be included in the owner’s adjusted gross estate as a non-business asset, thus making it more of a challenge to satisfy the 35 % test.

6166 Traps:

  • IDGT: With the sale of an appreciating business interest to a defective grantor trust estate planning strategy which is so popular these days, the business assets are sold for an installment promissory note. That sale reduces the amount of business assets held by the owner. The unpaid noted received by the owner from the trust will be held in the owner’s estate and it will be classified as a non-business asset. These two aspects of that strategy will make it that much harder for the deceased owner’s estate to meet the 35% test.
  • QTIP: Often the surviving spouse of the closely held business interest owner does not have any active involvement in the business, owned and operated by their spouse. If the business passes outright to that surviving spouse on the business owner’s death, and the survivor subsequently dies, the survivor’s estate will often not qualify for IRC 6166 estate tax deferral, as the survivor will not have actively participated in the business. In contrast, had the business owner originally left the closely held business to a QTIP marital deduction trust for the surviving spouse’s benefit, upon the surviving spouse’s subsequent death, the survivor’s estate can elect IRC 6166 estate tax deferral. If the predeceased spouse’s estate could have made a 6166 election with regard to those business assets, then the QTIP Trust that holds the business interest will also qualify for 6166 deferral in the survivor’s estate so long as there is no material change in the form or operation of those assets. [See PLR 200521914, May 27, 2005]

Conclusion:  Until Congress gets around to its promised tax reform, we still have to deal with the federal estate tax. One of the few helpful tax code sections that can be used to reduce the burden caused by federal estate taxes and its 9 month ‘payment-in-full’ rule is IRC 6166. While not all estates will have the opportunity to use IRC 6166, for those estates that hold closely held business interests, steps should be taken to preserve the ability to make that important election. That means carefully selecting assets if a lifetime gift program is contemplated, think twice before going forward with a sale to a defective grantor trust strategy comparing the benefits of that strategy with IRC 6166, and use a QTIP trust if the owner’s spouse is not, and will not, become active in the business after the owner’s death.