If you’re like many small business owners, it has taken years, and probably decades, to build a successful operation. Naturally, you hope that the business continues long after you’re gone, especially if you’ve brought children or other family members into the fold. But that’s not always the reality.
Frequently, heirs of successful entrepreneurs are forced to sell off business interests at “fire sale” prices to help pay a federal estate tax bill. The current top estate tax rate of 40% is triggered after applying the gift and estate tax exemption of $5.49 million. For example, absent other factors, if the taxable portion of a business interest amounts to $5 million, the estate owes a staggering $2 million (40% of $5 million) in tax.
Could this happen to your business? You can minimize the chances by taking some preemptive steps, including providing instructions for making a special election under Internal Revenue Code Section 6166.
How Sec. 6166 works
Sec. 6166 allows heirs to stretch out estate tax payments over time. Specifically, assuming certain conditions are met, the executor of the estate can elect to postpone any payment for five years before taking another 10 years to meet the tax obligations in equal annual installments. (This 15-year deferral is actually 14 years long because of the way payment due dates are structured.)
Thus, by buying extra time with the election, your family may be able to avoid a distress sale. However, this tax break isn’t automatically available. To qualify, three requirements must be met:
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The deceased must have been a U.S. citizen or resident at death.
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An interest in a closely held business must compose more than 35% of the deceased’s adjusted gross estate.
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The election must be made by the estate’s personal representative on an estate tax return filed in a timely manner.
The calculation of the 35% test is based on subtracting from the gross estate certain deductions, such as debts, funeral expenses, administration costs, mortgages and liens. However, these deductions are taken into account prior to applying any available charitable and marital estate tax deductions.
Moreover, the closely held business interest must qualify as an active trade or business. If the business is a passive activity, the value of passive assets must be removed before it can be determined if the value exceeds 35% of the adjusted gross estate.
Be aware that this estate tax deferral break isn’t limited to sole shareholders of C corporations. It’s also available for sole proprietors; partners with an interest of 20% or more in the partnership or with an interest in a partnership that has no more than 45 partners; and corporate stockholders owning 20% or more of the voting stock, or owning stock in a corporation with no more than 45 shareholders.
Other factors in play
If you intend for Sec. 6166 to be elected, be wary of certain actions that will accelerate payment of all the unpaid tax that has been deferred. For instance, payments may be accelerated because of sales, exchanges or other dispositions of 50% or more of the deceased’s interest. On the other hand, if the business redeems shares to pay for estate tax, funeral expenses and administrative expenses, this redemption won’t cause an acceleration.
Finally, there’s one more catch: Interest must be paid annually on the unpaid portion of the tax. However, the estate pays only 2% interest on the tax attributable to the first $1 million of the business interest. The interest rate for tax underpayments applies to any amount above the $1 million threshold, subject to inflation indexing. The threshold for 2017 is $1.49 million.
Don’t try this at home
Bear in mind that this technique is complex. Meet with your estate planning advisor to determine the availability of the Sec. 6166 election. This election should be coordinated with other aspects of your estate plan.
Sidebar: More life in life insurance
Regardless of whether your estate benefits from Section 6166, it may be advisable to secure additional life insurance coverage. This could be the easiest and most cost-efficient method for ensuring that your family will continue to operate your business after your death.
Not only does life insurance provide liquidity to pay estate tax immediately or through annual installments, but the proceeds won’t be included in your taxable estate if you make the necessary arrangements. Essentially, you can’t retain any ownership rights under the policy. For most business owners, this is a small price to pay for peace of mind.
