Estate tax relief for family businesses

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If a substantial portion of your wealth is tied up in a family or closely held business, you may be concerned that your estate will lack sufficient liquid assets to pay estate taxes. If that’s the case, your heirs may be forced to borrow funds or, in a worst-case scenario, sell the business in order to pay the tax.

For many business owners, Internal Revenue Code Section 6166 provides welcome relief. It permits qualifying estates to defer a portion of their estate tax liability for up to 14 years. During the first four years of the deferment period, the estate pays interest only, followed by 10 annual installments of principal and interest.

A deferral isn’t available for the total estate tax liability, unless a qualifying closely held business interest is the only asset in your estate. The benefit is limited to the portion of estate taxes that’s attributable to a closely held business.

Eligibility requirements

Estate tax deferral is available if the value of an “interest in a closely-held business” exceeds 35% of your adjusted gross estate. A business is closely held if it conducts an active trade or business and it’s:

  • A sole proprietorship,
  • A partnership or limited liability company — if your gross estate includes 20% or more of its capital interests or the entity has 45 or fewer partners or members, or
  • A corporation — if your gross estate includes 20% of its voting stock or the corporation has 45 or fewer shareholders.

To determine whether you meet the 35% test, you may only include assets actually used in conducting a trade or business — passive investments don’t count.

Active vs. passive ownership

To qualify for an estate tax deferral, a closely held business must conduct an active trade or business, rather than merely manage investment assets. Unfortunately, it’s not always easy to distinguish between the two, particularly when real estate is involved.

The IRS provided welcome guidance on this subject in a 2006 Revenue Ruling. The ruling confirms that a “passive” owner — such as a limited partner in a limited partnership — may qualify for estate tax deferral, so long as the entity conducts an active trade or business. The ruling also clarifies that using property management companies or other independent contractors to conduct real estate activities doesn’t disqualify a business from “active” status, so long as its activities go beyond merely holding investment assets.

In determining whether a real estate entity is conducting an active trade or business, the IRS considers several factors, including:

  • The amount of time owners, employees or agents devote to the business,
  • Whether the business maintains an office with regular business hours,
  • The extent to which owners, employees or agents are actively involved in finding tenants and negotiating leases, and
  • The extent to which owners, employees or agents perform or oversee repairs and maintenance and handle tenant repair requests and complaints.

The ruling provides several examples to illustrate the necessary level of involvement by owners or employees. In one example, the IRS found that a real estate business failed the active business test because it relied on a third-party management company to operate its properties. Nevertheless, the estate in the example qualified for a tax deferral because the deceased person owned at least 20% of the management company, which, together with the real estate, constituted a single, active business.

Weigh your options

As you plan your estate, consider whether your family will be eligible to defer estate taxes. If you own an interest in a real estate business, you may have an opportunity to qualify it for an estate tax deferral simply by adjusting your level of activity or increasing your ownership in an entity that manages the property.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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