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Estate Tax Strategies for Business Owners - Pat Soldano

Thank you to BNY Mellon Wealth Management for this report.

It’s critical that business owners leaving a large estate behind work with their Wealth Strategists to devise a plan that anticipates every eventuality and utilizes all the tools available to them.

In the absence of proper planning, the death of an owner of a closely held business may lead to an estate tax liability that can devastate the business, even with the increased federal estate and gift tax exemption under 2017 tax reform.

While business owners often desire to keep a family business within the family upon death, failure to plan appropriately can compel surviving family members to engage in a post-mortem fire sale of the business. Fortunately, planning for the estate tax is not limited to liquidity planning via buy-sell agreements and insurance. Estates can take advantage of statutory and common law strategies that allow them to defer payment of the estate tax, request an extension or secure liquidity via a loan.

Deferring Payment

While estate tax is typically due nine months from the date of death, section 6166 of the Internal Revenue Code offers estates the opportunity to defer federal estate tax attributable to a closely held business interest so long as three requirements are met:

  • The decedent was a citizen or resident of the United States
  • The value of the closely held business interest exceeds 35% of the adjusted gross estate
  • A notice of election is made on a federal estate tax return and is filed in a timely manner

If the estate satisfies the above requirements, the estate may pay the estate tax over a period not to exceed 14 years, the first four of which are typically interest only, with the final 10 equal payments of interest and principal. During this period, the estate will also pay a favorable rate of interest on the estate tax deferred.

What is a “Closely Held” Business?

Section 6166 applies only to an interest in a “closely held” business. Determining whether the decedent’s business is closely held depends on a two-part test:

  • The business must be engaged in an active trade or business as of the date of the decedent’s death
  • The nature of the business entity and the percentage ownership must fall into a particular category

These categories include:

  • An interest as a sole proprietor
  • An interest in a partnership carrying on a trade or business, if either the partnership had 45 or fewer partners or 20% or more of the total capital interest in such partnership is included in determining the decedent’s gross estate
  • Stock in a corporation if 20% or more of the value of the voting stock is included in the gross estate or the corporation had 45 or fewer shareholders (certain family attribution rules also apply)

The IRS will consider activities of the decedent, agents, and employees, and the partnership, limited liability company, or corporation to determine whether the activities constitute an active trade or business. A business’s use of independent contractors will not disqualify the business as an active trade or business as long as the business is not merely holding investment property. However, the use of an unrelated property management company that performs most of the activities associated with the real estate interests suggests that an active trade or business does not exist.

Planning Considerations

Executors should consider the following prior to electing under section 6166:

  • Unlike other estate tax deferral strategies, interest paid pursuant to section 6166 is not deductible as an expense of the decedent’s estate
  • The IRS may accelerate tax payments under section 6166 or require a special lien or bond as security for the deferred tax where concerns exist with respect to the stability of the business, the likelihood that future payments will be made in a timely manner and whether there is a history of non-compliance with taxing authorities
  • The existence of a buy-sell agreement may disqualify the estate under section 6166 because the owner is viewed as having previously contracted to dispose of the interest in the business

Requesting an Extension

Section 6161 allows the executor of an estate to request an extension of time for the payment of estate taxes for up to 12 months if the estate can show “reasonable cause” and, in cases where the estate can demonstrate “undue hardship,” the time for payment can be extended for one year up to 10 consecutive years.

What Constitutes Reasonable Cause?

Treasury regulations provide the following examples of what is reasonable cause:

  • An estate possesses sufficient liquidity to pay the estate tax; however, the liquid assets are not immediately subject to the control of the executor, even with the exercise of due diligence.
  • An estate comprises assets consisting of rights to receive payments in the future (i.e., annuities, royalties, contingent fees or accounts receivable). These assets provide insufficient liquidity to pay the estate tax when otherwise due and the estate cannot borrow against these assets except upon terms that would inflict loss upon the estate.
  • An estate includes a claim to substantial assets that cannot be collected without litigation. Consequently, the size of the gross estate is unascertainable when the tax is otherwise due.
  • An estate lacks sufficient funds (without borrowing at a rate of interest higher than that generally available) with which to pay the estate tax when otherwise due, to provide a reasonable allowance during the administration of the estate for the decedent’s widow and dependent children, and to satisfy claims against the estate. Furthermore, the executor has made a reasonable effort to convert available assets into cash.

What Constitutes Undue Hardship?

An extension beyond 12 months may be granted upon a demonstration of undue hardship, which requires more than an inconvenience to the estate. A sale of property at a price equal to its current fair market value, where a market exists, is not ordinarily considered as resulting in an undue hardship to the estate. The following examples illustrate cases in which an extension of time may be granted based on undue hardship:

  • A farm (or other closely held business) comprises a significant portion of an estate, but the requirements of section 6166 are not satisfied. Sufficient funds for the payment of the estate tax are not readily available. The farm could be sold to unrelated persons at a price equal to its fair market value, but the executor seeks an extension of time to facilitate the raising of funds from other sources for the payment of the estate tax.
  • The assets in the gross estate that will be liquidated to pay the estate tax can only be sold at a discounted price or in a depressed market if the tax is to be paid when otherwise due.

Unlike section 6166, interest paid pursuant to section 6161 is deductible as an expense of the decedent’s estate.

Graegin Loans

Estates that lack the liquidity to pay estate taxes or administrative expenses may be able to take advantage of a “Graegin loan,” so named after a much-cited 1988 Tax Court case in which a family sought to avoid the sale of their business following the owner’s death. In that case, the court held that the full amount of the projected interest payments on the loan could be deducted from the taxable estate up front. The family was able to both secure the liquidity needed to pay the estate tax via the loan, and reduce the overall taxable value of the estate by deducting the future interest payments up front.

To qualify for this treatment, the estate must demonstrate that:

  • The loan is a “bona fide debt,” i.e., it’s properly drawn up with real, enforceable terms and an expectation of repayment
  • The interest amount is “readily ascertainable,” meaning you need to be able to determine the total amount of interest payments in order to deduct it
  • The loan was “necessarily incurred,” i.e., there was a good reason to take out the loan, such as avoiding the liquidation of assets

In the original case, the loan was made to the family by the business itself; such arrangements may invite more scrutiny by the IRS than when a commercial lender is involved and provided the estate makes at least annual payments of interest. When working with a commercial lender, the primary concerns are that the estate truly is illiquid and that the interest rate is fixed and not subject to prepayment.

Protecting the Business and the Family

These are just some of the strategies that business owners and their families can avail themselves of in an effort to protect the business and ensure that the family legacy can be passed down to the next generation. It’s critical that business owners at risk of leaving a large estate behind without the liquidity to cover the associated estate tax costs work with their advisors — tax accountants, private bankers and wealth strategists — to devise a plan that anticipates every eventuality and utilizes all the tools available.

Thank you to BNY Mellon Wealth Management for this report.

CAUTION: Elimination of Step Up in Basis could destroy your business!

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Family Enterprise USA is the organization that represents all family businesses on a national level in DC; it is not unique to any industry. Family Enterprise USA is different from other organizations because it represents and advocates for the families of family businesses and the issues, they face running their businesses every day. Our sole mission and purpose is to promote family businesses and their job growth in America. We also support the work of Family Business Centers across the country. We hope your family will choose to be a member of Family Enterprise USA.