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Kimberly Leach Johnson is a partner in the Naples, Florida, office of Quarles & Brady LLP. Amalia Levit Todryk is an associate in the Milwaukee, Wisconsin, office of Quarles & Brady LLP.
A client with a taxable estate that consists largely of an interest in a closely held business that owns real estate needs to plan for liquidity or arrange the assets to take advantage of the Code § 6166 election to defer the payment of estate tax.
Generally, the federal estate tax is due within nine months of death. In illiquid estates, however, the executor may have a difficult time raising funds to pay the estate tax within that period without being forced to sell the property or business interest. Congress enacted Code § 6166 to remedy this situation and permit the deferral of payment of the federal estate tax in situations in which, to pay the tax, it would be necessary to sell business assets and possibly disrupt or destroy the business.
The purpose of Code § 6166 is summarized in Parrish v. Loeb : “Section 6166 was designed by Congress to create a safety valve to protect the integrity of closely-held business interests of a decedent against destruction because of the demands of the estate tax provisions of the Code.” 558 F. Supp. 921 n.2 (C.D. Ill. 1982).
Overview of Code § 6166 Requirements
Code § 6166 permits the decedent’s estate to elect to pay all or part of the estate tax attributable to the decedent’s interest in a closely held business in up to 10 equal annual installments, with the first tax installment deferred up to five years. For an estate to qualify for the Code § 6166 election, the decedent must have been a citizen or resident of the United States at the time of death, the value of the interest in the closely held business that is included in the gross estate must exceed 35% of the decedent’s adjusted gross estate (the “35% Test”), and the executor must make the election on a timely filed estate tax return. Louis A. Mezzullo, Paying the Estate Tax in Installments: Now More User Friendly , 34 ACTEC J. 48, 49–50 (2008) (discussing the requirements to qualify under Code § 6166); see also Dennis I. Belcher, How to Meet Liquidity Needs in a Private Business Owner’s Estate Using IRC Section 6166, IRC Section 303, and Graegin -Style Promissory Notes , paper initially prepared for the 39th Annual Heckerling Institute on Estate Planning (Oct. 24, 2005), at 10–24 (discussing the requirements to qualify under Code § 6166).
For purposes of Code § 6166, the term “adjusted gross estate” means “the value of the gross estate reduced by the allowable deductions under Code § 2053 or § 2054, based on the facts and circumstances existing on the due date, including extensions for filing the estate tax return or, if earlier, on the date the return is filed.” Mezzullo, supra, at 49. The values used for meeting the 35% Test are the same as those used for determining the federal gross estate. Thus, if the estate is valued under alternate valuation or special-use valuation, those values must be used to meet the percentage requirements.
Code § 6166 defines an “interest in a closely held business” to mean:
To determine the value of an interest in a closely held business and whether or not the 35% Test is met, the advisor needs to exclude passive assets held by the business. Code § 6166 defines “passive asset” to mean any asset not used in carrying on a trade or business. For instance, if the business bank account of a decedent, who is the owner of an apartment building, contains both nonbusiness funds as well as funds that are earmarked for a new roof or other capital expenditures, the nonbusiness funds would be considered a “passive” asset and would not constitute an interest in a closely held business for purposes of meeting the 35% Test.
Interests in two or more closely held businesses may be treated as a single business if 20% or more of the total value of each business is included in the decedent’s gross estate. For purposes of meeting the 20% requirement, the surviving spouse’s interest in the business is treated as included in the decedent’s gross estate if the interest was owned with the decedent as community property, joint tenants, tenants by the entirety, or tenants in common. Belcher, supra, at 13.
The maximum amount of tax that can be paid in installments is the portion of the estate tax attributable to the closely held business. This is the amount of tax that bears the same ratio to the total estate tax that the value of the closely held business included in the gross estate bears to the adjusted gross estate. The estate taxes attributable to an interest in a closely held business, exclusive of interest, may be deferred for up to five years from the original payment due date and then may be paid in two but not more than ten installments.
During the deferral period, interest is due annually. The interest and tax must be paid at the same time. The interest rate on the estate tax attributable to the first $1.330 million in 2009 (which is indexed for inflation) is 2%. The balance of the estate tax deferred under Code § 6166 bears interest at a rate equal to 45% of the interest rate applicable to underpayments of tax under Code § 6621.
A Code § 6166 election provides many benefits: (1) the estate is not forced to sell the assets of the closely held business to pay the estate tax; (2) the future income of the closely held business can be used to make the installment payments; (3) the estate has an option if it cannot obtain a bank loan to pay estate tax; and (4) the interest rate is reduced on the deferred estate tax payments. Robert E. Madden et al., IRS Provides Guidance Regarding Real Estate and Active Business Requirement of Section 6166 , 33 Est. Plan. 41 (2006) (discussing the advantages of the election).
Pre-Rev. Rul. 2006-34
In a series of revenue rulings in the 1970s, the IRS took the position that, for an interest in a business to qualify under Code § 6166, it has to conduct an active trade or business, not just merely manage investment assets.
Rev. Rul. 75-365, 1975-2 C.B. 471, considered whether or not a decedent’s business office that collected rent, received payments on notes receivable, negotiated leases, made occasional loans, and arranged for the maintenance of the properties with outside vendors qualified as an “interest in a closely held business.” The IRS ruled that the decedent’s business did not constitute an active trade or business and that the “decedent’s relationship to the various assets described was merely that of an owner managing investment assets to obtain the income ordinarily expected from them.” The IRS explained:
Although the management of rental property by the owner may, for some purposes, be considered the conduct of business in the case of a sole proprietorship, section 6166 was intended to apply only with regard to a business such as a manufacturing, mercantile, or service enterprise, as distinguished from management of investment assets. . . .
. . . [T]he mere grouping together of income-producing assets from which a decedent obtained income only through ownership of the property rather than from the conduct of a business, in and of itself, does not amount to an interest in a closely held business within the intent of the statute.
Rev. Rul. 75-365.
Rev. Rul. 75-366, 1975-2 C.B. 472, involved a decedent who participated actively in important management decisions of a tenant farm. The decedent made almost daily visits to inspect and discuss operations and occasionally delivered supplies to the tenants. The ruling holds that “farming under these circumstances is a productive enterprise which is like a manufacturing enterprise as distinguished from management of investment assets.” Therefore, the decedent’s farm assets constitute an interest in a closely held business.
The IRS held that the decedent’s ownership of all of the stock in a corporation that built homes on land that was owned and developed by the decedent, along with a business office and warehouse used by both the corporation and the decedent in the decedent’s development activities, constituted an interest in a closely held business for puroses of Code § 6166. But the IRS held that the eight homes that were owned by the decedent and rented to tenant farmers and for which the decedent collected rents, made the mortgage payments, and performed necessary maintenance and repairs did not constitute an interest in a closely held business for purposes of Code § 6166 because the decedent’s “relationship to the rental properties was merely that of an owner managing investment assets to obtain the rents ordinarily expected from them.”
If a decedent owned real estate but had agents, employees, and/or independent contractors involved in the use and management of the real estate, the issue often arises of whether or not the decedent had the necessary “active” business involvement to qualify for Code § 6166.
Rev. Rul. 2006-34
Until 2006, it was clear that “passively owning real estate and collecting rents was a passive activity.” Belcher, supra, at 17. Thankfully, Rev. Rul. 2006-34 (the “Ruling”), 2006-1 C.B. 1172, provides a non-exclusive list of factors that help to determine when real estate activities will qualify as an “interest in a closely held business” for Code § 6166 purposes. The Ruling revoked Rev. Rul. 75-365 and the portion of Rev. Rul. 75-367 that held that the decedent’s eight homes did not constitute an “interest in a closely held business.”
The Ruling states that in determining whether the activities of the decedent, partnership, LLC, or corporation (“the business”) constitute an active trade or business, activities of the agents and employees of the business are to be taken into consideration. In a real estate business it is common for day-to-day operations and activities to be performed by independent contractors, such as property management companies. The Ruling goes on to provide that just because some of the activities of the business are conducted by third parties will not prevent the business from qualifying as an active trade or business, so long as these third-party activities are not so extensive as to reduce the activities of the business (and its agents and employees) to the level of merely holding investment property. If a real estate business uses an unrelated property management company to perform most of the activities associated with the real estate interests, an active trade or business most likely does not exist.
The Ruling states that, in determining whether a decedent’s interest in real property is an interest in an asset used in an active trade or business, the IRS will consider all of the facts and circumstances, including the activities of agents and employees, the activities of management companies or other third parties, and the decedent’s ownership interest in any management company or other third party. The Ruling contains the following non-exclusive list of factors that will be considered (all references to the “decedent” include the decedent’s agents, employees, partnerships, LLCs, or corporations):
The Ruling provides that no single factor is dispositive of whether a decedent’s real property activities (or the activities of a partnership, LLC, or corporation through which the decedent owns the real property) constitute an interest in a closely held business for purposes of Code § 6166. The Ruling goes on to apply these factors to five situations. In each situation, the other requirements of Code § 6166 were met, that is, the 35% Test, and so on.
At the time of A’s death, A owned a strip mall. A personally handled the day-to-day operation, management, and maintenance of the strip mall and most of the repairs. When A was unable to personally perform a repair, A hired an independent contractor and then reviewed and approved the work performed. The IRS found that A provided significant services to the strip mall tenants and that A’s activities went beyond those of a mere investor collecting profits from a passive asset. The use of independent contractors on occasions when A could not personally perform the work does not prevent A’s activities from rising to the level of the conduct of an active trade or business. Thus, A’s ownership of the strip mall qualifies as an interest in a closely held business for purposes of Code § 6166. This result would be the same if instead the strip mall had been held in a single-member LLC owned by A and the LLC were disregarded as an entity that is separate from its owner.
At the time of B’s death, B owned a small office park. The office park consisted of five separate buildings, each of which had multiple tenants. B hired a property management company, in which B had no ownership interest, to lease, manage, and maintain the office park and B relied entirely on this company to provide all necessary services (including advertising, leasing, collecting rents, and arranging all maintenance related to the property). The management company provided a monthly accounting statement to B, along with a check for the rental income, net of expenses and fees. The IRS stated that in determining whether B was a proprietor carrying on a trade or business, the activities of the management company and its relationship with B were taken into account. The IRS found that because the management company performed all necessary services and B did not have an ownership interest in the management company, B did not significantly participate in the management or oversight of the property, B was not a proprietor in an active trade or business, and B’s interest in the office park did not qualify as an interest in a closely held business for purposes of Code § 6166.
Same facts as in Situation 2, except that B owns 20% of the stock of the property management company. The IRS found that because B owned a significant interest in the management company, the management company’s activities respecting the office park allowed B’s interest in the office park to qualify as an interest in a closely held business for purposes of Code § 6166.
At C’s death, C owned a 1% general partner interest and a 20% limited partner interest in a limited partnership (LP). The LP owned three strip malls that, collectively, constituted 85% of the value of the LP’s assets. The partnership agreement required C, as the general partner, to provide the LP with all services necessary to operate the LP’s business, including daily maintenance to and repair of the strip malls. C received an annual salary from the LP for his services as general partner. C (either personally or with the aid of employees or agents) performed substantial management functions, including collecting rents, negotiating leases, performing daily maintenance and repairs (or hiring, reviewing, and approving the work of third-party independent contractors for such work), and making decisions regarding renovations to the malls. Because the LP, rather than C, owned the strip malls, the nature and level of the activities of the LP must be evaluated to determine whether the LP was carrying on an active trade or business. The IRS found that the LP, acting through its general partner C, handled the day-to-day operations and management of the strip malls. Thus, the LP carried on an active trade or business. Because the strip malls were used in carrying on the partnership’s active trade or business, they were not passive assets and their value was not excluded from the value of C’s interest in the partnership and C’s interest in the partnership qualified as an interest in a closely held business for purposes of Code § 6166. (Because C owned at least 20% of the partnership, the result would be the same even if C’s activities were instead performed by another employee, partner, or agent of the partnership.)
At D’s death, D owned 100% of the stock in an automobile dealership corporation. D made all decisions regarding the corporation and supervised all of its employees. In addition, D owned a parcel of real property that was leased by the corporation and used as a showroom, office space, service center, and for storing inventory. The corporation’s employees performed all maintenance and repairs to the real property. The IRS concluded the corporation was conducting an active trade or business (an automobile dealership). Consequently, D’s interest in the corporation qualified as an interest in a closely held business. Because the real property was used exclusively in the business of the corporation under a net lease from D, who owned a significant interest in the corporation and whose activities respecting the real property constituted active management, D’s interest in the real property also qualified as an interest in a closely held business.
Rev. Rul. 2006-34 provides guidance to advisors on how to structure their client’s business affairs to qualify for the Code § 6166 election. To determine if Code § 6166 will be beneficial to a client’s estate, the advisor needs to estimate the estate tax liability based on the current value of the client’s assets and then determine whether or not there is a lack of liquidity to pay these taxes. If it looks like there will be a liquidity shortfall, the advisor needs to consider the options. Can the client afford to purchase a life insurance policy to cover the liquidity issues? Depending on the type of asset, is it likely the estate can borrow money from a bank to pay the tax? Even if bank borrowing is an option, does the client want to rely on this option?
Planning Ideas for Code § 6166 During Lifetime
If the advisor determines that a Code § 6166 election may be beneficial to solve a client’s liquidity issues, then he or she must determine whether the estate will meet the requirements of Code § 6166. First, do the assets meet the 35% Test? If not, what steps can the client take during his or her lifetime to rearrange the assets? Perhaps the client should consider making lifetime gifts of nonbusiness assets to increase the value of the closely held business interest. On the other hand, if the client currently meets the 35% Test, the advisor needs to make sure the client does not gift interests in a closely held business that could cause the client to fall below the 35% Test. Stephen H. Gariepy, A Safari Through the Land of Estate Tax Payments: Federal and Ohio , 18 Ohio Prob. L.J. 83 (2007) (discussing steps to qualify for Code § 6166). It is important to note that, in accordance with Code § 2035(a), the 35% Test also must be met if gifts made within three years of the client’s date of death were included in the gross estate. Belcher, supra, at 35 (general discussion of lifetime planning ideas); see also Gariepy, supra.
If real estate that is used in connection with a trade or business is owned by the client directly or an entity outside of the operating business entity and is leased to the operating business entity, the real estate may not qualify as a trade or business and may cause the client to fail the 35% Test. Belcher, supra, at 35. One solution is to transfer the real estate to a business entity that conducts an active trade or business; however, this can cause asset protection issues. Id. Another solution is to have the entity that owns the real estate perform additional maintenance and management tasks related to the real estate to qualify the entity as an active trade or business. Id.
If a client is concerned its real estate business will not qualify as an active trade or business, the client can consider increasing its active management of the real estate and decreasing the role of independent contractors. If the client currently uses an outside management company to manage its real estate interests, the client could consider starting its own management company, if feasible. If the client owns its own management company, the advisor should analyze whether or not the management company needs to increase the role of its own employees in the management of its properties and decrease the role of independent contractors to qualify as an active trade or business. Gariepy, supra.
If a client owns real estate through its interests in a business and these interests are subject to a buy-sell agreement, the advisor should analyze the buy-sell agreement. If the agreement requires the interest to be purchased at death, make sure it is for cash and not for a promissory note, as the note is a passive asset and could prevent the deferral under Code § 6166. Id.
The level of management activity should be documented during the client’s lifetime to ensure that the real estate business is engaged in an active trade or business. A review of the factors listed in Rev. Rul. 2006-34 will show whether or not the real estate business is an active trade or business. Therefore, if the estate is audited, it will be able to prove to the IRS that the real estate business was an active trade or business.
Planning for Code § 6166 After the Fact
In illiquid estates, the advisor needs to compare the valuation discounts on the business interests and determine whether the estate would benefit more from qualifying for the Code § 6166 election or the estate tax savings from lower valuations of the business interests. If it seems that Code § 6166 is the best option, then less aggressive valuation discounts should be taken on the business interests to meet the 35% Test. If discounts are available on the nonbusiness assets, these should be taken to meet the 35% Test. Belcher, supra, at 35 (general discussion of postmortem planning ideas); see also Gariepy, supra.
It is important to note that Code § 6166 provides that any unpaid portion of the estate tax, which would otherwise be payable in installments, will be due and payable on notice and demand by the IRS if 50% or more of the closely held business interest that qualifies for installment payments is distributed, sold, exchanged, or otherwise disposed of; or 50% or more of the value of the closely held business interest that qualifies for installment payments is withdrawn from the business. A distribution of the closely held business interest to any person who is entitled to it by reason of the decedent’s death will not trigger acceleration, nor will any subsequent distribution cause acceleration so long as the transfer is to brothers, sisters, spouse, ancestors, or descendants of the transferor. Acceleration also will not occur if the transaction is a mere change in form. BNA Tax Mgm’t Est. Gifts & Tr. Portfolios, Series No. 855-2nd, Estate and Trust Administration—Tax Planning, A-29. This means that the advisor’s role is not finished once an estate successfully qualifies for the Code § 6166 election.
During the deferral period, a clear understanding of the rules is important so that no action is taken that will inadvertently accelerate the unpaid tax. If the business interest is sold, make sure the client retains sufficient cash to pay the remaining estate tax that may be accelerated. The worst result is to have an acceleration and only a promissory note to pay the tax.
During these tough economic times and with the possibility that a new administration will increase estate tax rates and lower the estate tax exemption, advisors need to work with their clients to plan for the payment of estate taxes. Borrowing money from a bank is not the option it used to be. Code § 6166 is a tool that clients can take advantage of with proper planning.
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