Estate Tax Strategies for Business Owners

To be sure, active planning to reduce the taxable estate is important. However, for owners of illiquid assets (such as real estate, art or a closely held business) there are also potential strategies to examine to ensure that estate taxes are paid as efficiently as possible. Here we will highlight a few strategies to consider.

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

These are rather technical requirements and tax professionals should be consulted to determine qualification. However, If the estate satisfies the above requirements, the estate may pay the estate tax over a period not to exceed 14 years where only interest is due on the amount borrowed during those first four years with the final 10 equal annual installments consisting of payment of interest and principal. During this period, the estate could benefit from paying a favorable rate of interest on the estate tax deferred. See ‘Borrowing from the IRS’ below.

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
• The sale or other disposition of 50% or more of the business will accelerate the deferred taxation

Requesting an Extension To Pay Tax

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.

Arranging to Borrow

Executors of large estates often face heavy cash needs when the estate’s assets are illiquid. Rather than instituting a forced sale of an asset, which can be untimely for a variety of reasons, financing options may be attractive.

Borrowing from the IRS

To satisfy an estate tax obligation, when assets include a closely held business (or certain farm assets) that have a value in excess of 35% of the decedent’s estate, there may be some relief under US tax law in the form of a government loan. The IRS can lend at a determined rate provided that the borrower meets specific requirements under Section 6166. A few downsides include: the annual interest payments are not deductible; the loan is subject to a variable rate during the term; and, formal closing of the estate could be delayed1.

Graegin Loans

A Graegin Loan2 is another tool to consider. For any asset that is illiquid, the estate can borrow money from a financial institution to pay the estate tax. Because of the treatment of qualifying Graegin Loans by the IRS, the estate can reduce the total tax due. Under recently adopted Treasury Regulations3 when properly structured, a formula amount of the interest due over the term of the Graegin Loan is immediately deductible for estate tax purposes. Essentially, the Estate reduces its estate tax liability by the interest due over the term of the loan. So, not only does the Graegin Loan provide liquidity, it also reduces the overall tax liability.

The downside to Graegin Loans is that to qualify there is no prepayment option. For example, if the business were sold in year 3, although proceeds are immediately available, the loan has to be serviced until term. Compared to using Section 6166 when the asset is sold, the deferred liability can be paid and interest stops accruing.

Protecting the Business and the Family

These are just some of the strategies that executors and families can utilize. It is critical that business owners who are at risk of leaving a large estate behind without liquidity to cover associated estate tax devise a plan that anticipates every eventuality and utilizes all the tools available.

One thing often missed is the importance of continuing to monitor the assets in your estate to provide for optionality. The ability to option into a certain tax position may provide the favorable outcome intended for an estate. Your BNY Wealth team can work closely with your tax and legal advisors and help you analyze these complex strategies.