Criteria for helping preserve wealth and dealing with estate liquidity issues using Internal Revenue Code Section 6166.
One of the ways a successful family business can lose value is to be consumed by the need to sell assets to meet estate taxes. Those who inherit a business have several ways to handle estate taxes after the death of an owner, including deferral of the estate tax payment for those who qualify.
According to the Internal Revenue Code section 6166, a personal representative may defer payment of estate taxes if the interest in a closely held business exceeds 35 percent of the decedent’s adjusted gross estate.
Section 6166 spells out several criteria that must be satisfied before the estate may be eligible to defer the payment of federal estate taxes:
- The decedent must have been a U.S. citizen or resident at death.
- An interest in a closely held business must comprise more than 35 percent of the decedent’s adjusted gross estate.
- The estate’s personal representative must make the section 6166 election on a Form 706 Federal Estate Tax Return filed in a timely manner.
Meeting these requirements may allow the estate to defer federal estate tax attributable to the closely held business, with principal and interest on the deferred tax paid over a 14-year period. The guidelines for deferring estate taxes and calculating and making payments are complex. Be sure to work with your tax advisors to understand the requirements and how they may apply to your situation.
Meeting the 35 percent threshold
If you are considering using section 6166 to defer payment of estate taxes, work with your tax advisor to determine whether the estate’s interest in the closely held business is at least 35 percent of the decedent’s adjusted gross estate. Calculations start by taking the gross estate and subtracting deductions allowable under IRC sections 2053 and 2054, such as debts, funeral expenses, administration costs, mortgages, and liens.
However, such deductions are taken into account prior to applying any available charitable and marital estate tax deductions.
For example, consider these two scenarios of decedents who were U.S. citizens and died in 2022, leaving a closely held business, investments, and cash.
$13 million: Value of gross estate
$3.6 million: Value of the decedent’s closely held business
$.4 million: Debts and estate expenses (to be satisfied with cash)
$12.6 million: Adjusted gross estate calculated after paying expenses, but before applying the marital deduction
In this case, the $3.6 million closely held business interest represents 28.57 percent of the adjusted gross estate and does not meet the 35 percent threshold. As a result, estate tax deferral benefits would not be available.
$15 million: Value of gross estate
$3.92 million: Value of the decedent’s closely held business
$8 million: Debts and estate expenses (to be satisfied with cash)
$7 million: Adjusted gross estate calculated after paying expenses, but before applying the marital deduction
In this example, the $3.92 million closely held business interest represents 56 percent of the adjusted gross estate. This exceeds the 35 percent threshold and estate tax deferral benefits would be available if the business meets the other two requirements above.
This information is hypothetical and is provided for informational purposes only. It is not intended to represent any specific return, yield, or investment, nor is it indicative of future results.
If you fail to meet the 35 percent threshold
If you do not qualify for section 6166, one option to consider is a loan from a third party lender. Commonly referred to as a Graegin loan, this strategy, which resulted from the Graegin vs. Commissioner U. S. Tax Court case, may permit an estate to borrow money to pay for estate taxes while allowing an immediate deduction of all of the interest due on the loan, thereby reducing the federal estate tax liability.
To be deductible, the interest must be able to be reasonably estimated, and it must be certain that the interest will be paid. Typically, a bank or other institution is the lender. In certain circumstances, a loan can be taken from an irrevocable life insurance trust or a related family business; however, those transactions are closely scrutinized. Be sure to consult with your tax and legal advisors before pursuing this option.
Acceleration of the deferred tax
If you plan to use section 6166, you should be wary of certain actions that will accelerate the payment of all unpaid tax that has been deferred. 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 payment of all unpaid tax will be accelerated. In addition, the payment of all unpaid tax may be accelerated if you fail to make a payment within six months of the due date.
If, on the other hand, the business redeems shares to pay for estate tax, funeral expenses, and administrative expenses, the redemption will not face an acceleration of the unpaid tax.
If you do decide to liquidate certain holdings in the course of conducting business and the assets continue to be used or owned by the business, acceleration of estate taxes will not occur. However, acceleration will occur if the business liquidates assets and distributes the proceeds to the shareholders to engage in separate businesses.
Seek outside advice
Although section 6166 has been widely used to deal with a looming estate tax bill, its rules are complex, its application is ambiguous in certain circumstances, and it may be unsuitable for actual business structures. As a result, when you analyze whether or not to use this strategy, you should conduct proper due diligence with your tax and legal advisors to determine if section 6166 is appropriate and cost-efficient or whether you should be considering another strategy.
Wells Fargo Wealth & Investment Management (WIM) is a division within Wells Fargo & Company. WIM provides financial products and services through various bank and brokerage affiliates of Wells Fargo & Company.
Wells Fargo and Company and its affiliates do not provide tax or legal advice. This communication cannot be relied upon to avoid tax penalties. Please consult your tax and legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your tax return is filed.
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