• IRS Ruling Clarifies Estate Tax Deferral for Some Family Business Owners
  • May 8, 2008 | Author: Reeve E. Chudd
  • Law Firm: Ervin Cohen & Jessup LLP - Beverly Hills Office
  • Under current law, the payment of the estate tax liability which results when someone dies ("the decedent") is due nine months after the decedent's date of death. For people whose wealth is primarily cash and marketable securities, this time frame is usually quite manageable, but, where a person's wealth is tied up primarily in less liquid assets, such as an ownership share in a family owned business, this nine month period may not be sufficient for the surviving family to generate the cash to pay the estate tax. An important function of your family business team, including attorneys, accountants and financial planners, is to anticipate estate tax costs which could cripple a family business without careful planning.

    Often the risk of this liquidity problem is solved with life insurance, to be available at death to cover estate taxes. But sometimes the life insurance is not available (or is exorbitantly expensive) for current health reasons, or life insurance purchased in the past is not adequate to cover the estate tax attributable to a greatly appreciated business or property. If this is the case, the Internal Revenue Code (the "Code") provides some relief to cash strapped, business rich families to permit them to pay part of their estate tax bill over time.

    Section 6166 of the Code provides that, if more than 35% of the value of a decedent's estate is comprised of interests in closely held businesses ("CHB"), the estate may elect to defer the estate taxes attributable to the CHB's value as follows: a) the first 5 years at interest only and b) the next 10 years in payments of interest and principal. By allowing the survivors to defer payment of these estate taxes, Section 6166 effectively gives the family a statutory right to "borrow" this tax amount from the U.S. Government, with no loan approval process, loan origination fees or costly loan maintenance reporting, and with an interest rate usually below that charged by banks.

    The Code defines an "interest in a closely held trade or business" as: a) an ownership in a proprietorship which runs a business, or b) an interest in a partnership, limited liability company or corporation which carries on a trade or business if 20% or more of the capital interests of the entity (partnership shares, memberships or capital stock) are part of the estate and there are fewer than 46 partners/members/shareholders. Interest paid on a Section 6166 deferral is not deductible, but is usually at a rate which is less than 50% of the rate charged by the Internal Revenue Service (the "IRS") on underpayments of the income tax. For example, the interest rate on underpayments in August, 2006 is 8%, compounded daily, and so the interest rate on an installment payment of estate taxes under Section 6166 would be about 3.6%. Effective June 16, 2006, the IRS issued Revenue Ruling 2006-34, which gives greater clarity as to which families will be eligible to pay estate taxes on an installment basis under Section 6166. With this clarification, families whose assets are primarily illiquid businesses and real estate interests can adjust their holdings and operations to increase their potential for utilizing this beneficial program.

    Specifically, this Revenue Ruling helps clarify how "active" the decedent had to have been in the business in order for that business to qualify as a CHB. The Ruling specifies that activities of the "agents and employees" of the decedent or of the CHB will be attributed to the decedent in evaluating whether there is an "active" trade or business being run. So, even if the decedent merely sits at home and collects dividends or rent checks paid to him by the family owned business in which he has an interest, if the company has its own agents or employees who actively manage its business, the company will be deemed a qualifying CHB under Section 6166.

    Ordinarily, this test will be easily met by companies with active operations distributing goods or providing services since, of necessity, they will have employees and agents performing the activities of the business. But, this will also be available to family partnerships with real estate holdings, as long as the partnership has its own agents or employees actively managing the underlying property. Further, even if the partnership or other entity engages the services of an independent real estate management company, as long as this does not reduce the activity of the decedent and/or the partnership to the mere passive "holding of investment property", the partnership interest may still qualify as a CHB.

    So, how can a family which owns real estate interests adjust their activities in order to have a better chance at qualifying for Section 6166? First, the family should take an active role in managing the property, with family members employed by the entity owning the real property. What level of activity should these employed family members have? They should have normal business hours, remain active in procuring new tenants, including the negotiation of leases, and possibly participate actively in the maintenance operations of the property, such as arranging for and/or performing repairs and maintenance and handling tenant complaints.

    Often we have advised clients who have significant real estate interests to involve their children in these functions, and even to have the children, who train on the family property, possibly branch out to manage the property of others through a separate management company. Normally, the engagement of a separate management company to take care of all landlord functions makes the property a passive investment, disqualifying it for Section 6166 treatment. However, if it is the family operating the management company, and the decedent owned at least 20% of the management company as well as the partnership or other entity owning the real property, the IRS has ruled that the decedent's interest in both the land-owning entity and the management company will qualify as a CHB, eligible for Section 6166 relief.

    Your particular family and business situation will dictate the planning necessary to enjoy the estate tax deferral benefits of Section 6166, with the guidance of this Revenue Ruling.