We have long extolled the virtues of succession planning for family business owners. Discussions around this topic often focus on the tax, creditor, and control advantages of using trusts to transfer value in the family business to the next generation while the senior level retains control over business operations by retaining all voting stock in the business. Early planning can help ease the stress after a founder’s death that often comes from raising liquidity quickly to pay estate taxes on a business.

Occasionally, though, a family business owner may be unwilling or unable to give or sell a meaningful portion of the ownership of the business to successive generations. Perhaps the founder is reluctant to relinquish ownership of the company she and her spouse have worked so hard to build, or maybe an unexpected death or incapacity makes it legally impossible to proceed with estate planning that is started but incomplete. What can be done to minimize the immediate impact of federal estate tax on the business and family under these circumstances?

The answer may lie in section 6166 of the Internal Revenue Code (IRC), which in certain situations permits the executor of an estate to defer federal estate tax on a closely held business following an owner’s death. If the code’s requirements are met, the executor can elect to defer and spread payment of the estate tax attributable to the decedent over a period of up to 14 years. In the early years of the deferral period, installment payments to the Treasury can be made as interest only.

Estate tax deferral under this IRC section relates solely to the portion of the decedent’s estate that represents his ownership in the company. In addition, it is only available to the extent the decedent’s ownership in the closely held business accounted for at least 20% of the company’s value and more than 35% of the value of his adjusted gross estate at the time of death. If these requirements are met, the executor should consider making the election to defer federal estate tax due on that portion of the estate related to the value of the business.
 

Interest and Principal Payments
An executor of an estate must pay the federal estate tax due on a closely held business ownership interest within nine months of the date of the decedent’s death.

Assuming the husband and wife in the earlier example had used up their respective applicable exclusions during life, the estate would have to raise cash to pay federal estate tax of approximately $20 million within nine months of his death.¹ If, instead, the executor elected to defer the portion of the estate tax related to the interest in the family business, the estate could defer approximately $8 million (the portion of estate tax due on the business) in tax. This buys the company time to either generate cash to pay the deferred tax or arrange an orderly sale of the business, as it relieves the executor of having to raise such a large pool of capital in a short time.

This is what Congress designed section 6166 deferral to do for family business owners. What happens to the tax liability then? The estate must begin paying interest to the Treasury annually from the date the tax was due (nine months from death) and start paying the principal tax balance no later than the fifth anniversary of the due date. Principal and interest deferral can be continued up until the 14th anniversary of the date the tax was due.

For decedents dying in 2023, the interest rate is 2% on the first $1.75 million in taxes deferred and a variable rate of interest only on the balance. This means the annual interest payable by the husband’s estate in the first four years of deferral is a small fraction, compared with $8 million of estate taxes that would be due within nine months of his death absent the 6166 deferral election. When the estate begins making principal and income payments to the Treasury in year five, a lien will be placed on all assets that qualified for deferred taxes (that is, the business interest) to secure full payment of the deferred taxes and interest.

Electing Deferral
Once the executor has the family business and other estate assets appraised, he or she must elect 6166 deferral for the business interest to ensure it pays the proper amount of tax due for the nonbusiness estate assets, which are ineligible for 6166 tax deferral. This is done on either the application for an extension of time to file an estate tax return or on the return itself.

It is important to begin the process of appraising the business as soon as possible because business appraisals are subjective and can take time to prepare, particularly if there are multiple business lines that must be appraised to determine a value for a single holding company stock. The estate has nine months to obtain an appraisal and, even with the appraisal in hand, bears the risk that the Internal Revenue Service (IRS) may challenge the business’s appraised value on audit, which could ultimately jeopardize the executor’s election.

Suppose the IRS successfully challenges the business’s value in the husband’s estate and finds that the company is worth only $10 million. In that case, the value of the family business would not exceed 35% of the decedent’s total estate, which would be reduced by a corresponding amount to $40 million, yielding a ratio of 25%. This is a factor an executor must consider before electing 6166 deferral.

Family Attribution
IRC section 6166 deferral was intended by Congress to benefit all forms of actively owned and managed family businesses, allowing relief to extend to businesses owned and operated as sole proprietorships, LLCs, partnerships, and corporations.

Consistent with the goal of providing estate tax relief to family businesses, the number of owners who can own a business is capped for certain forms of ownership. A corporation electing 6166 deferral cannot have more than 45 shareholders, and a partnership or LLC cannot have more than 45 partners or members, respectively. This is not as high a bar as it may seem, because the IRC permits certain family members to aggregate their ownership not only for the number of owner thresholds, but also for the ownership percentage qualification tests addressed earlier.

Conclusion
Many families actively pursue succession planning or the sale of a family business during the life of the founders and successive generations. Succession planning is an ongoing process – never a finished product. However, sometimes life or other familial issues get in the way of a family’s plans, and IRC section 6166 should be considered under the correct circumstances.

Some families aggressively plan to utilize 6166 deferral, particularly where a senior generation refuses to transfer ownership in the family business. These families work together to spend down or gift away assets that the business does not need and retain ownership at the senior level to ensure a greater portion of the senior generation’s estate represents ownership in an active trade or business eligible for 6166 election. Note that the 2% interest rate on the first $1.75 million in taxes deferred mentioned earlier is fixed, but interest that must be paid on the remainder of deferred taxes ($6.25 million in the earlier example) is a variable rate tied to other sections of the IRC. In the current rate environment, interest rates are attractive where a senior business owner is elderly or against surrendering her interest in the business. That said, because of the nuances of IRC section 6166, careful consideration should be given before relying on 6166 deferral as the definitive succession plan for the family business.

If your family owns a family business and you would like to discuss any aspect of succession planning, including how to plan to take advantage of 6166 estate tax deferral, learn more about the Brown Brothers Harriman Center for Family Business.