One of the ways to build the American Dream is to create and grow a successful family-owned business. And one of the quickest ways to reduce wealth is to allow high estate taxes to hinder the business through a forced sale of assets.
Failure to plan for the transition of a family business due to the death of an owner or significant shareholder can create undue stress on cash flow and other financial resources of the estate and threaten the viability of the closely‑held business.
Insurance, buy-sell agreements and gifting strategies are popular planning techniques used to fund and plan the estate tax problem away. These lifetime planning techniques can provide liquidity, create a potential market for sale of the business, or shift assets and future appreciation out of the estate.
However, if there has been a lack of successful planning for liquidity of the estate, there are still various ways to handle payment of the estate tax without selling the business.
Deferral of the Estate Tax
Internal Revenue Code §6166 allows a personal representative to defer estate taxes if the interest in a closely‑held business exceeds 35 percent of the decedent’s adjusted gross estate.
For the estate to defer the payment of estate taxes, the following elements must be satisfied:
If the estate satisfies these elements, the estate tax attributable to the closely‑held business interest(s) may be deferred, with principal and interest on the deferred tax paid over a 14-year period.
During the first four years following the due date of the return, only the interest on the deferred tax must be paid. The interest rate on the deferred tax is assigned a special, fixed 2 percent rate on a portion of the tax.
If the deferred tax exceeds certain limits ($486,500 for a death in 2012), the excess is subject to interest at a fluctuating rate that is 45 percent of the regular rate for underpayment (determined quarterly—currently 3 percent). Beginning five years after the return is due, the deferred tax and interest are payable in equal annual installments over as many as 10 years.
If the business interest is sold or if distributions are made to the owners and the sale or distributions represent at least half of the value of the interest included in the estate, then the deferral period ends and any remaining installments become due and payable upon demand by IRS. The deferral period may also be terminated by a failure to make timely payment of any installment of tax or interest.
There really should not be any excuse for missing a payment because the IRS sends an annual reminder about 30 days before each installment is due. The reminder also requires the executor or designated agent to sign a statement that certifies that the status of the estate remains unchanged since the last installment payment and that the executor or designated agent will notify the IRS within 30 days if the status changes.
IRC §303 Redemption
IRC §303 permits an estate to get cash out of a corporation (either a C corporation or an S corporation) with minimal or no income tax consequences to the extent cash is needed to pay federal and state death taxes, costs of estate administration and funeral expenses.
The §303 redemption has some similar prerequisites to the §6166 deferral and may be used in conjunction with estate tax deferral once the installment payments begin.
The stock’s value must exceed 35 percent of the deceased shareholder’s adjusted gross estate and the shareholder and close family must hold at least 20 percent of the value of the corporation to qualify.
Normally, an unequal distribution of cash in redemption of stock is treated as a dividend to the redeeming shareholder who continues to hold controlling interest in the corporation after the redemption. However, §303, can help an estate escape a forced sale of the business to pay estate taxes, without having a partial stock redemption taxed as a dividend.
To the extent the distribution does not exceed the taxes and certain estate expenses, it will be treated as a sale of the stock. Since the stock receives a stepped-up basis on the death of the shareholder, the capital gains consequences should be minimal.
Graegin Loans
In limited circumstances, an estate may be able to reduce its estate tax liability through timely payment of the tax rather than using a tax deferral or redemption. In Estate of Graegin v Commissioner, the Tax Court allowed an estate to deduct the interest on a loan used to pay estate taxes as an administrative expense on the estate tax return. Graegin’s estate consisted mostly of closely-held stock and had very little liquidity.
The note provided that all principal and accrued interest was due in a single balloon payment at the end of the fifteen year note term, and neither principal nor interest could be prepaid.
Of significance is that the amount of interest payable be certain. Therefore, the note cannot permit prepayment of interest or principal. In addition, in order for the balloon interest to be deductible, the estate must show that it had no way of paying estate taxes other than through a forced sale of illiquid assets. Otherwise, the interest payment is not a reasonable and necessary expense. Additionally, there must be a clear expectation that the loan can and will be repaid under the stated terms.
One tricky part of using a Graegin loan lies in determining the amount of loan necessary to pay the estate tax. Since the tax liability is reduced by the interest deduction, the amount that must be borrowed is also reduced. So a slightly complex calculation is required.
Also, the party loaning the funds will have to pay income tax on the interest received, so the overall tax savings may depend on the tax bracket of the interest recipient when the interest is paid.
Though illiquidity of the estate can be avoided through timely planning and a little luck, there are alternatives to “selling the family farm” to pay estate taxes. Armanino’s Family Wealth Group can help the executor of an asset-rich, but cash-poor estate make the right decisions when the time comes.
April 12, 2012
