§6166 Deferral and Other Tools for the Illiquid Estate

Tax News You Can Use | For Professional Advisors

Estate and financial planners often make their illustrations of paying estate tax look simple. For example, an estate is worth $50 million, the client has used their full exemption making lifetime gifts and the tax is imposed at a marginal rate of 40%, so the estate pays $20 million of estate tax and $30 million remains for the executor to distribute in accordance with the estate plan. And while the number payable to Uncle Sam is large, all assets in the calculation and the accompanying illustrations are assumed fungible and liquid. The executor can simply write a check for the $20 million in tax due and the beneficiaries can ride off separately into the sunset with their respective shares of the residue.

Identifying the problem

Those who advise executors and others administering estates and trusts after the testator’s death know that such circumstances are rarely, if ever, the case in the real world – particularly when the decedent owned an interest in a closely held business. Actual estates have illiquid assets, indivisible assets and other demands on cash flow that make payment of the tax a more challenging problem.

Let’s look at an example. Suppose the $50 million dollar estate consists of the following:

This estate has $5,000,0000 in liquid assets in the portfolio. While the IRA assets may be liquid, those assets are payable to the beneficiary of the IRA, so that is not available for estate tax payments (withdrawing assets from an IRA creates additional tax liabilities too, so that is another obstacle). The estate also must pay debts, expenses (which will include maintaining the homes and collections until they are sold) and other taxes (for example state death taxes, income tax, or property tax). Even if, miraculously, both homes, the boat and the car collection could be liquidated immediately, the estate would still have only $15 million in liquidity after the payment of debts and expenses, which leaves an $8 million liquidity shortfall when the estate tax bill comes due nine months after death.

What is §6166?

Congress realized that paying estate tax would impose a liquidity burden on owners of illiquid business interests. They decided that if the business is an ongoing operating business owned by a family or a small number of shareholders and it represents a sufficiently large proportion of the estate, then the estate would qualify to finance its estate tax obligations by deferring the portion of the tax attributable to the business interest and then paying in interest-bearing installments. These provisions are found in §6166 of the Internal Revenue Code, entitled "Extension of time for payment of estate tax where estate consists largely of interest in closely held business."

An estate that qualifies for §6166 treatment must make an affirmative election. If the election is made, the estate must compute the proportion of the estate that consists of the business interest and may defer the same pro rata portion of the estate tax for five years from the due date for the estate tax return. After the deferral period, the estate then must make annual payments of at least two and not more than ten installments. This means that the final payment is due no later than 15 years and 9 months after the decedent’s death. Interest must be paid annually, including during the period of deferral. A portion of the tax obligation bears interest at only 2%, while the rest bears interest at 45% of the regular interest rate on tax deficiencies. For 2024, it is 2% on the first $740,000¹ of tax, and 3.6%² on the remaining amount.

What are the requirements to qualify to elect §6166 deferral?

The election is available for estates of decedents who were United States citizens or residents on the date of death. This is because it is based on the proportion of the business interest to the entire worldwide taxable estate, which is only taxable for those who are citizens or residents at the time of death. The value of the business interest must equal or exceed 35% of the adjusted gross estate. For a business owner whose estate includes interests in multiple businesses, none of which exceed 35% of the estate alone, it is possible to aggregate the interests to meet that prong of the test if at least 20% of each business is included in the decedent’s estate.

There are restrictions on the types of business interests that qualify. First, the interest must be in a "closely held" business that is not "readily tradable." Closely held business is defined as a proprietorship, an interest in a partnership where at least 20% of the partnership is includible in the decedent’s gross estate OR where there are 45 or fewer partners, or a corporation where at least 20% of the voting stock is includible in the decedent’s gross estate OR where there are 45 or fewer shareholders. A stock is not readily tradeable if there is no market on a stock exchange or over-the counter. The entity must be engaged in a trade or business. Interests in passive assets do not qualify for deferral.

Stock in a holding company may qualify for some but not all of the benefits of §6166. To the extent that the underlying assets of the holding company are qualifying businesses, an interest in a holding company can qualify to pay tax in installments. There is no five-year deferral, and no portion of the tax qualifies for the 2% interest rate, but the ability to pay in ten installments can be very helpful. Similarly, stock in a lending or finance business does not qualify for the deferral period or the 2% interest rate, but can qualify to pay the tax in up to five annual installments.

What does this mean for the estate?

Making a §6166 election buys an illiquid estate of a business owner some breathing room. Instead of payment in full due nine months after the date of death, the first payment is not due until 5 years and 9 months after death, and the tax can be paid in ten annual installments in years 5-15. If the plan for paying the tax is to sell the business, using deferral can avoid a fire sale and give the estate time to find a strategic buyer. If the estate is going to pay the tax using income generated by the business, there is a longer time for the income to be generated. The policy behind this is to enable the estates of owners of active businesses to have more time to pay the tax to increase the probability that the business will continue operating after the death of the principal.

What does this mean for the business?

The death of the founder or significant owner of a closely held business can be a tumultuous time for the business itself, particularly if the death happens unexpectedly. There may be issues related to indebtedness personally guaranteed by the deceased owner. There may be a need to shore up customer or vendor relationships after the founder is gone. There also may be challenges to the leadership succession process. When this occurs, the profitability of the company can dip and the company’s ability to borrow funds may be curtailed. By eliminating the demand of the estate for immediate and full redemption of shares to pay the estate tax by its ordinary due date nine months after death, the business also gets some breathing room and a chance to regroup and make deliberate plans.

What is a §303 redemption?

Section 303 of the Internal Revenue Code permits the tax-free redemption of shares from a decedent’s estate for the purpose of paying for estate taxes and expenses of administering the estate. This is useful where there is liquidity in a C corporation that needs to be used for the payment of taxes owed by the estate. It is often used in connection with §6166 deferral when the company does not have sufficient liquidity to redeem all the stock at once. It is also only available for a closely held business that represents 35% or more of the decedent’s estate. A caveat for those estates that use §303 and §6166 together is that they must carefully coordinate the two provisions so that the redemption does not disqualify the estate from the extended deferral.

What about life insurance?

A recent United States Supreme Court case has also made redemption a less attractive approach for generating liquidity, particularly if the source of funds is life insurance. In Connelly v. United States, the court held that in valuing the company for estate tax purposes, the insurance proceeds are added to the operating value of the company without reduction for the obligation to purchase the shares. A better approach when life insurance will be providing the liquidity is to have the insurance policy owned by an irrevocable life insurance trust that is not includible in the business owner’s estate for estate tax purposes. In that case, the policy proceeds can be used to buy the shares from the estate to provide liquidity to the estate for taxes and expenses, and the redemption is avoided.

What are the downsides of deferring estate tax?

There is an interest cost associated with deferral of the tax that cannot be overlooked. Deferral is essentially borrowing from the IRS, so executors may want to compare the cost of borrowing from the IRS against the cost of other borrowing opportunities. It is definitely simpler to take out a loan and use it to pay the tax on time rather than relying on deferral of the tax. Whether the interest rates for §6166 deferral are attractive will depend in large part on where the interest rates applicable to intra-family and third-party loans are at the time of death and during the following years. One option available if the funds are borrowed to pay tax from a third party is taking a current interest expense deduction on the estate tax return. This is only possible if the loan prevents prepayment, so that there is a guarantee that the interest will be paid.

Compliance with §6166 deferral is complex. Throughout the sixteen-year period, the estate tax amount will be recalculated to deduct the interest paid, so there will be legal or accounting expenses to claim this deduction and to monitor the ongoing qualification of the estate and the business for deferral. If the business is sold by the estate or the company is sold or no longer qualifies as a closely held business, then the tax obligations will be accelerated. Making the election, particularly in combination with a redemption under §303, can also limit how much cash can be distributed from the business for other purposes. There will be a tax lien on the property that will need to be addressed before the property can be sold, and which can also impact the business’s and the estate’s ability to borrow for other purposes.