Implementing creative solutions has allowed your business to thrive and stay one step ahead of the competition. Quite possibly, the toughest challenge lies ahead paying estate taxes.
Federal estate taxes are due nine months after death, and the IRS wants payment in cash not stock, real estate, etc. Your business, while quite valuable, is a highly illiquid asset. Your heirs may not have ready access to the funds needed to pay estate taxes and other final expenses. In the worst-case scenario, they may be forced to sell the business to raise funds needed to pay estate taxes.
IRC Section 6166: A Deferred Payment Schedule
The IRS created Section 6166 of the Internal Revenue Code because of the burden estate taxes place on business owners and their families. If your business qualifies, Section 6166 permits the executor of your estate to pay the portion of the estate tax attributable to your business in installments, as opposed to one lump sum. During the first four years, the executor of your estate may elect to only pay interest on the outstanding estate tax due. Thereafter, annual installments of both interest and principal are due for 10 years.
On the surface, a deferred payment schedule may seem attractive. Your estate avoids the immediate burden of a lump-sum payment, allowing your business to run its normal course of operations. In the long run, however, there are several potential pitfalls:
- Interest on the Installment Payments The IRS assesses a two percent interest rate on the portion of tax attributable to the first $1,000,000 ($1,120,000 as adjusted for 2003) of the business. But after a full deduction of the Unified Credit allowed against the estate tax, the two percent rate only applies to the first $493,800 (in 2003) of tax. The remainder of the tax will be subject to 45% of the rate applicable to tax underpayments.
- Tax Lien The IRS places a tax lien on your business to ensure that all installment payments are met. Your estate will remain open and unresolved for the duration of the installment period. The greater debt may adversely affect the company's credit and hinder its ability to raise funds.
- Acceleration of Unpaid Taxes What happens if profits drop dramatically, which is quite possible over the course of a business cycle? If the executor of your estate misses one scheduled installment payment, the IRS can demand the immediate payment of all unpaid taxes. If the delinquent payment is submitted within six months, the tax will not be accelerated, but the two percent rate will not apply for the payment; instead, a five percent per month late payment penalty will be imposed. The sale, exchange, distribution, or withdrawal of one-half or more of an interest in the business also terminates the extension of time for the payment of taxes under Section 6166 and triggers the acceleration of any unpaid taxes.
- Non-Business Interests Deferred payments under Section 6166 are not available for federal estate taxes attributed to non-business interests. Even if your executor elects the Section 6166 option, your estate still needs enough liquidity to meet administrative expenses, cash bequests, state death taxes, and additional federal estate taxes. Your estate also needs liquidity to pay interest, principal (deferred estate tax), accountant and attorney fees for 14 years.
Section 6166 can also put an added strain on your family and business. Consider the following:
- Does a sufficient source of funds exist to cover the business and your family through the duration of the installment payment period?
- How will your heirs pay their own living expenses?
- Can your heirs wait until the entire estate tax is paid before the payout of final distributions?
Life insurance may relieve the risk and uncertainty that the business will fail to qualify for the Section 6166 election or the estate will have the cash flow needed to meet its annual obligation. Death benefit proceeds are income tax free and are immediately available to your named beneficiary(ies). If an irrevocable life insurance trust owns the policy, where the trustee is the applicant, owner, and beneficiary, with family members as beneficiaries of the trust, the proceeds should not be subject to federal estate taxes.
In addition, the premiums paid for a life insurance policy today may be significantly lower than the cost of paying interest, principal, accountant, and attorney fees for 14 years.
Does Your Business Qualify?
To qualify under Section 6166, your "interest in a closely held business" must exceed 35 percent of your adjusted gross estate. The term "interest in a closely held business" means:
- An interest as proprietor in a trade or business carried on as a proprietorship, or
- An interest as a partner in a partnership carrying on a trade or business, if 20 percent or more of the total capital interest in such partnership is included in determining the gross estate of the decedent, or such partnership had 45 or fewer partners, or
- Stock in a corporation carrying on a trade or business if 20 percent or more in value of the voting stock of such corporation is included in determining the gross estate, or such corporation had 45 or fewer shareholders.
Source: Internal Revenue Code Section 6166 (b) (1)
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