Estate Tax- What Every Business Owner Must Know About the 2017 Estate Tax
Federal Estate Tax-How the IRS Becomes Your Beneficiary through the Federal Estate Tax
In 2017, the applicable federal estate tax exclusion is $5.49 million. Under federal law there is a gift tax and an additional generation skipping transfer tax. The $5.49million exclusion applies to both the lifetime gift and generation skipping transfer amount.
Federal law provides for the “portability” of any unused exclusion amount on the death of the first spouse. Thus, if the husband should die first and not use his entire $5.49 million exclusion, then the unused portion can be transferred to his wife for use in his wife’s estate when she dies. This portability is not automatic, and must be elected at the first death. Depending on the specific facts and the size of the estate, election of portability may be appropriate. The net effect is that a married couple with proper planning can transfer $10.98 million free of estate, gift and generation skipping tax to their children and grandchildren. Once the estate exceeds the exclusion amount, estate, gift and generation skipping taxes are imposed at 40% for all excess amount.
An individual may give $14,000 per year to each done free of gift tax and it will not reduce his or her lifetime exemption. If a husband and wife give gifts to a single done, they can give a total of $28,000. This can be a valuable planning strategy to reduce the size of a person’s estate, by giving gifts of $14,000 or less to their children while they are alive.
Wait There is More-The State of Oregon Wants to Be Your Beneficiary Through its Inheritance Tax
Oregon is a decoupled state, meaning it has its own inheritance tax in addition to the federal estate tax. Once an estate is in excess of $1.0 million, then the estate is taxed at inheritance tax rates starting at 10% and increasing to 16% as the estate size increases. Unlike the federal law, there is no portability of any unused portion of the first to die spouse’s exemption to the second spouse.
In 2017, the individual Oregon exemption is $1.0 million. This exclusion amount is available at death. Oregon does not have a gift tax. A husband and wife combined can transfer at death $2.0 million estate tax free to their children in 2017. $1.0 million is exempt at the first death and another $1.0 million is exempt when the second spouse dies. The Oregon exemption is not indexed for inflation and has remained at $1.0 million for several years. Oregon does not provide for portability of the unused exemption.
Section 6166-How Is Your Family Going to Pay Taxes When You Leave Them Behind? Pay Later Rather than Earlier- Active Trade or Business and 35% Gross Estate Rule
Under the Internal Revenue Code your family, through the executor of your estate may defer the payment of estate taxes. IRC 6166, available to a closely-held business (corporation, partnership, but not an LLC) that consist of an active trade or business engaged in manufacturing, mercantile, or service functions can defer payment of estate taxes. Taxes which cannot be deferred under this section include gift taxes, generation skipping transfer tax, special use valuation recapture tax, QFOBI recapture tax, personal income tax on beneficiaries of estates. Section 6166 allows the deferral of payment of federal estate taxes if your interest in a closely held business exceeds 35 % of your adjusted gross estate. The deferral is limited to federal estate tax and does not apply to any other taxes which might be due after your death. In addition, you must have been a U.S. citizen or resident at the time of death, and the estate’s personal representative must make the IRC 6166 election in a timely manner. If all three of these conditions are present, the estate may elect to pay the tax imposed up to 10 equal installments. If this election is made the first installment must be paid no later than 5 years after the date prescribed by the code. This in effect defers payment of the principal and interest on the deferred estate tax up to 14 years. During the first 4 years only the interest on the deferred tax must be repaid. Beginning in year 5 the deferred tax and interest are payable in equal annual installments over 10 years.
To calculate the 35% of the decedent’s adjusted gross estate, there are certain deductions from the gross estate that are taken. These deductions are taken into account prior to consideration of either available charitable and marital estate tax deductions.
Another Gotcha- The Holding Company Exception
If you own stock in another corporation, the business is classified as a holding company. In this case, the other corporation stock would be treated as a passive asset in determining if the 35% threshold is met. Only an active business, not one that manages passive investments, qualifies for IRC 6166 treatment. However, the holding company election can be made if the other company is in an active trade or business and has 45 or fewer shareholders, or the decedent owned 20% or more of the businesses’ voting stock. In this case, the five-year deferral and the low interest rate will not be available.
There is a second holding company exception. For the second exception, the company must own 20% or more of the voting stock of the subsidiary and no more than 45 shareholders. In addition, 80% or more of the assets of the subsidiary must be used to carry on an active trade or business.
The Family Attribution Option
This option can be used when:
- The decedent owned least that 20% under the value test;
- Less than 20% under the capital interest test for a partnership with more than 45 partners(discussed above); or
- Less than 20% interest in a corporation with more than 45 shareholders.
Under the family attribution rule, for purposes of meeting any of the 20% threshold, any interest owned by family members will be “attributed” to the decedent.
Application of the attribution rule can be tricky. For example, if the decedent owns 12% in a qualifying entity and his family owns 10%, then for purposes of the 20% test, the decedent’s estate would qualify. However, the size of the decedent’s estate is not increased by her family’s 10% interest. It is needless to say, that most business owners could not determine the computations to know if the deceased estate qualified for the deferral.
Don’t Do This or You Will Lose the Deferral
Certain actions can result in acceleration of the deferred tax. If there is a distribution, sale, exchange, disposition, or withdrawal of 50% or more of your interest in the closely held business after the date of your death, the payment of all unpaid taxes will be accelerated. Also, a liquidation with distribution of the proceeds to the then existing shareholders that is used to engage in a separate business, will result in an acceleration of payment of estate tax. A strategy to avoid acceleration is to use a redemption of shares and use the money to pay certain expenses such as funeral, administrative, and to pay the estate tax.
Be Careful with Limited Liability Companies and IRC 6166
Section 6166 does not expressly include LLCs as one of the types of entities that qualify for a section 6166 deferral. However, there are private letter rulings that do include LLCs as a covered type of entity. The IRS’s position is that it will strictly enforce the statute. It appears that a single member LLC would qualify for section 6166, but a fractional interest in an LLC might not qualify.
How Can You Make Sure Your Family Can Qualify for the Deferral of Payment of Any Estate Tax?
Section 6166 is complex and subject to conflicting interpretation. You and your advisor will need to make a detailed analysis of the facts while you are alive, and make any adjustments to structures in order to qualify for the estate tax deferral.
How Can a Smart Business Owner Get the Money to Pay Estate Taxes?
Under IRC 303, when a business is a closely held corporation, a deceased shareholder’s estate or her heirs may sell to the corporation enough stock, subject to a limit for the amount adequate to pay federal and state death taxes, costs of estate administration, and funeral expenses, without treating the transaction as a dividend to the redeeming shareholder. What does this mean for your family? If set up correctly, they can defer payment of any estate taxes and put the money to pay the taxes in an investment account to accrue interest until the taxes are due. Without this provision in the code, the sale of the decedent’s stock would be fully taxable.
What amount qualifies for section 303 treatment? This section is limited to estate, inheritance and succession taxes along with the amount of funeral and administration expenses allowable as a deduction under the code. This raises the possibility that no federal estate tax is due, but a State estate tax is due and would trigger section 303. Another quirk is that the amount of the distribution does not have to be used for taxes, funeral expenses, and administrative expenses. Those expenses are only used to determine the limit on the tax free distribution.
Finally, to qualify under section 303, the redeemed stock is included in the decedent’s estate value and must be at least 35 percent of the adjusted gross estate. Unfortunately, you will not know these values until after death. There are other restriction such as qualifying distribute and time limits, but the usual problem is money. Where does the company get the money to perform the redemption?
What if your business does not have the money to redeem our shares? A problem that occurs often is that a closely-held business does not have enough cash to redeem a deceased shareholder’s stock. This is one reason for succession planning during your life.
Through the use of life insurance, when you die, the corporation has access to life insurance policy proceeds to purchase your stock. When a partial redemption is done through the use of life insurance, ownership of the business may remain in the family in a family-owned business. Further, the heirs of the deceased are assured of funds to pay estate taxes.
The redemption is tax-favored, and the redemption may be made even if there is other cash available. On the other hand, the redemption exposes the new owners to market risk, and there may not be sufficient capital surplus to pay for the redemption. While the favored way to go is to plan early and revise a business succession plan as time goes on and events and circumstances change, if you are like a majority of business owners-procrastinators when it comes to business succession planning- then post mortem use of section 303 may be a strategy available to your heirs.
Start Your Business Succession Planning Now While More Options are Available to You
Russ Pike is an engaging speaker, author, and passionate estate and elder law attorney. Russ is known for understanding his client’s needs and explaining complex areas of the law in a way that non-lawyers understand. Russ helps his clients by providing strategies and plans that will not only minimize taxes and protect assets, but will also ensure that wealth is transferred to the person intended. Russ works closely with families to minimize the occurrence of those situations you have heard about where family members are at each other’s’ throats over their inheritance. Russ is the author of two books, “Estate Planning for the Not Yet Wealthy” and “I Wasn’t Ready Yet! Survivor’s Guide to Handling a Loved One’s Estate.”
If you would like to learn more about the planning options available to you, pick up the phone and give Russ a call at 503-888-0952 to schedule a free consultation. During the consultation, which usually cost $295, you will have all your questions answered and receive at least one actionable strategy that you can implement.