A critical element to business succession planning is making certain the business owner’s estate will have the cash to pay estate taxes without having to sell the business. This article will examine the advantages and disadvantages of four such commonly used techniques – IRC Section 6166, IRC Section 303, Graegin loans, and life insurance.
IRC Section 6166
IRC Section 6166 permits the legal representative of the business owner’s estate to pay the portion of the estate tax attributable to the business in installments. During the first four years, interest only is due. Thereafter, annual installments of both interest and principal are due over 10 years.
While Section 6166 can be useful, it does have several drawbacks. First, in order to qualify under Section 6166, the business interest must exceed 35% of the business owner’s adjusted gross estate. Second, interest accrues at the rate of 2% on the deferred tax on the first $1,340,000 (indexed for inflation) of the business interest in excess of the applicable estate tax exclusion amount. But the interest rate on the deferred tax in excess of that amount bears interest at 45% of the rate applicable for tax underpayments (i.e., the short-term applicable federal rate plus 3% adjusted quarterly). Moreover, the interest paid under IRC Section 6166 does not qualify as an administration expense and is not deductible on either the estate tax return (Form 706) or on the estate’s income tax return (Form 1041). Third, the IRS can place a tax lien on the business until all installment payments are met. This lien may make it difficult for the business to borrow from banks and other lenders. Finally, the IRS can demand immediate payment of all unpaid taxes if the estate misses one scheduled payment, or if there is a sale or exchange of one-half or more of the business.
IRC Section 303
IRC Section 303 permits heirs to get cash out of a corporation (either a C corporation or an S corporation) with minimal or no income tax consequences to the extent needed to pay federal and state death taxes, costs of estate administration, and funeral expenses. Thus, Section 303 can help an estate escape a forced sale of the business to pay estate taxes, without having a partial stock redemption taxed as a dividend.
But Section 303 is not without its disadvantages. First, the stock’s value must exceed 35% of the deceased shareholder’s adjusted gross estate to qualify. Second, where will the cash to redeem the decedent’s stock come from? The corporation may not have excess cash with which to redeem stock. And, if the corporation attempts to accumulate cash to redeem stock, it may be subject to a 15% accumulated earnings tax. IRC Sections 531-537. Finally, like any other redemption, a Section 303 redemption can alter the ownership percentages of the surviving shareholders.
Graegin Loans
In Graegin v Commissioner, 56 T.C.M. 387 (1988), the Tax Court allowed an estate to deduct (as an administration expense on the estate tax return) the interest on a loan used to pay estate taxes. In Graegin, the estate consisted mostly of closely-held stock and had very little liquidity. So, instead of selling stock; or redeeming stock under IRC Section 303; or paying the estate tax on installments under IRC Section 6166, the estate borrowed the funds to pay estate taxes from a wholly-owned subsidiary of the closely-held corporation.
The note provided that all principal and accrued interest was due in a single balloon payment at the end of the note term, and neither principal nor interest could be prepaid. The Tax Court allowed the estate to deduct the entire balloon interest payment. Of significance is that the amount of interest payable be certain. Therefore, the note cannot permit prepayment of interest or principal. In addition, in order for the balloon interest to be deductible, the estate must show that it had no way of paying estate taxes other than the forced sale of illiquid assets. Otherwise, the interest payment is not a reasonable and necessary administration expense. See PLR 200513028 (Sept. 15, 2004).
Unfortunately, the Tax Court in Estate of Black v Commissioner, 133 T.C. No. 15 (Dec. 18, 2009), struck a blow to Graegin loans. In Black, the estate entered into a Graegin-type loan with an FLP. The Tax Court ruled that the loan was not “necessarily incurred” within the meaning of Treas. Reg. Sec. 20.2053-3(a) and, therefore, the interest (approximately $20,296,274) was not a deductible administration expense under IRC Section 2053(a)(2). The Tax Court found that the FLP could have redeemed the estate’s partnership interest shortly after the taxpayer’s death in order to provide the funds with which to pay the estate tax. This fact rendered the loan unnecessary. The Tax Court also emphasized that the decedent’s son stood on both sides of the loan – as the general partner of the FLP and the executor of the estate. But, it’s not clear from the Tax Court’s ruling whether the outcome would have been different if an independent party had served as the executor.
The problem with the Tax Court’s reasoning in Black is that, had the FLP redeemed the estate’s partnership interest shortly after the deceased partner’s death, the IRS would likely have included in the decedent’s estate any partnership interests gifted during the decedent’s lifetime. In Estate of Erickson v Commissioner, T.C.M. 2007-107, an FLP provided funds for the payment of the deceased partner’s estate tax liabilities. The Tax Court in Erickson reasoned that this was tantamount to making funds available to the decedent resulting in retained enjoyment and, thus, estate tax inclusion under IRC Section 2036(a)(1).
Life Insurance
The complexity and potential challenges of using Section 6166, Section 303, or Graegin loans, reinforces the advantages of using an irrevocable life insurance trust (“ILIT”) to pay estate taxes. An ILIT offers the following advantages:
1. The accumulation of cash values is not subject to current income taxation; the trustee can access cash values tax free (by surrendering to basis and/or borrowing); and the death proceeds are not subject to income taxes.
2. Gifts of life insurance premiums of up to $13,000 ($26,000 if married) can qualify for the annual gift tax exclusion, thereby avoiding current gift taxes.
3. Gifts of life insurance premiums also decrease the grantor-insured’s estate, potentially lowering federal estate taxes.
4. For two reasons, the internal rate of return for most insureds will be favorable compared to alternative investments. First, in the case of a premature death, the insurance policy produces an unparallel return on investment. Second, since the death benefit is income tax free, the projected rate of return is enhanced. The internal rate of return can be calculated and easily illustrated by the insurance advisor.
5. Finally, life insurance provides the business owner’s estate the liquidity it needs exactly when it’s needed, regardless of whether the estate qualifies under Section 6166, Section 303, or Graegin. The death proceeds received by the ILIT can be used to purchase assets from the business owner’s estate or to loan funds to the estate or to the business directly.
An ILIT can also play a role in the other strategies discussed above. For example, if at the time of the business owner’s death the estate qualifies under Section 6166 and the interest rates are favorable, paying the estate tax in installments may prove useful. But, if the estate subsequently runs into problems paying the installments, the ILIT can assist by purchasing assets from the estate or loaning funds to the estate on favorable terms.
The same is true with a Section 303 redemption. Assuming the estate qualifies for Section 303 treatment, but the corporation does not have sufficient cash to redeem the deceased shareholder’s shares. The ILIT could loan a portion of the death proceeds to the corporation to help it consummate the redemption. This is preferable to having the corporation be the owner and beneficiary of the policy, thereby increasing the value of the business for estate tax purposes.
Finally, if the ILIT loans the business owner’s estate the funds it needs to pay estate taxes and structures the loan to be a Graegin loan, the estate may qualify to deduct all of the balloon interest (as an administration expense). Of course, this assumes that the IRS does not successfully challenge the loan under the rationale of the Black case.
In summary, an ILIT is a popular and effective tool to help meet the estate liquidity needs of a business owner. Due to its tax-advantaged status, an ILIT is an ideal way – standing alone or in conjunction with other planning opportunities – to fund estate taxes, thereby assuring that the family business stays in the family.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.
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