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Inter Vivos Planning

I. Inter Vivos Planning

The adjusted gross estate is determined by deducting from the gross estate only those items permitted under Sections 2053 and 2054, namely, funeral expenses, administration expenses, claims against the estate, unpaid mortgages and indebtedness on property and casualty losses.  The formula used to determine if an estate satisfies this 35 percent threshold raises two important considerations that are not readily apparent.

A. The Adjusted Gross Estate is Determined Prior to the Application of any Charitable or Marital Estate Tax Deduction.

For example, assume a decedent dies in 2008 with an estate valued at $15 million, comprised of (i) $500,000 cash that will be used to pay debts and expenses of the estate, (ii) $10 million of additional cash and marketable securities that will pass to a charity, and (iii) a closely held business valued at $4.5 million, 100 percent of which will pass to the decedent’s children.  The decedent’s estate plan provides that taxes are charged against the assets includable in the decedent’s taxable estate.

At first glance, this example would appear to be the perfect example of an estate that Section 6166 is intended to benefit.  The client executed this estate plan to ensure continuity of family ownership and control of the closely held business.  Further, the decedent’s entire taxable estate is comprised of a closely held business that will pass to his children.  This estate, however, does not qualify for Section 6166 deferral because the 35 percent test is not applied to the taxable estate of $4.5 million (after the deductions for debts, expenses, and the charitable gift).  Rather, it is applied to the adjusted gross estate of $14.5 million (after the deductions for debts and expenses, but before the charitable deduction).

The executors will be faced with an estate tax of $1,125,000, but the only assets available in the taxable estate to pay such taxes are illiquid.  To pay estate taxes, the executors will be forced to obtain third party financing, request discretionary extensions to pay estate taxes from the IRS, or consider a forced sale of the closely held business.

Careful planning can alleviate these issues.  Inter vivos gifts of cash or other non-closely held business assets can increase the relative size of the closely held business as compared to the client’s other assets.  By making such gifts, the client can be sure that his or her interest in the closely held business comprises over 35 percent of the client’s adjusted taxable estate.

For example, if the above-described decedent had made $2 million of charitable gifts more than three years before his death, his gross estate would have been valued at $13 million (and such lifetime gifts presumably would have qualified for a valuable income tax charitable deduction).  Because the closely held business valued at $4.5 million is more than 35 percent of the adjusted gross estate of $12.5 million, the decedent’s estate would have qualified for Section 6166 deferral, allowing his executors to defer $405,000 of the $1,125,000 in estate taxes.

B. The Decedent’s Interest in the Closely Held Business Need not Pass to any Particular Beneficiary.

The closely held business can pass to a spouse or charity, and the estate may qualify for Section 6166 deferral notwithstanding that no estate tax is directly attributable to the closely held business.  Because Section 6166 deferral is based on the adjusted gross estate rather than the taxable estate, Section 6166 can create an apparent windfall if the closely held business is distributed to a charity or spouse.  For example, assume that a decedent dies in 2008 with an estate valued at $13 million, comprised, in part, of cash and securities of $5 million.  From this amount, $500,000 will be used to pay debts and expenses of the estate, and $4.5 million will pass to the decedent’s children.  Assume the remainder of the estate is comprised of a closely held business valued at $8 million, all of which will pass to the decedent’s spouse.  The decedent’s estate plan provides that taxes are charged against the assets includable in the decedent’s taxable estate, which pass to the children.

In this example, none of the decedent’s taxable estate is comprises of the closely held business.  Instead, all estate taxes are attributable to the cash and marketable securities passing to the children.  Notwithstanding that the executors clearly have sufficient cash and liquid assets to pay the total estate taxes due of $1,125,000, and that none of the estate taxes are attributable to the closely held business, Section 6166 permits the executors to defer $720,000 of the total estate taxes.

II. Active Business, Rather Than Passive Investment

For an estate to qualify for Section 6166 deferral, the closely held business owned by the estate must be an active trade or business.  However, neither the Code nor the Regulations define the term” business” for this purpose.  The IRS has provided that to qualify for Section 6166 deferral, the business must consist of a manufacturing, mercantile, or a service enterprise rather than the mere management of passive assets.[1]

In particular, the IRS has scrutinized whether a decedent’s real estate holding will be considered a closely held business for purposes of Section 6166.  If the holdings are considered mere passive investments, they will not be considered a closely held business.  If, however, the decedent’s activities rise to the level of managing an active business rather than a passive investment, the estate may qualify for Section 6166 deferral.

Revenue Ruling 2006-34 addresses whether a decedent’s interest in real estate will qualify as a closely held business for purposes of Section 6166.  Specifically, the ruling provides that the IRS will consider the following nonexhaustive list of factors:

  1. Whether an office was maintained from which the activities of the decedent, partnership, LLC, or corporation were conducted or coordinated, and whether the decedent (or agents and employees of the decedent, partnership, LLC, or corporation) maintained regular business hours for that purposes;
  2. The extent to which the decedent (or agents and employees of the decedent, partnership, LLC, or corporation);
    1. was actively involved in finding new tenants and negotiating and executing leases;
    2. provided landscaping, grounds care, or other services beyond the mere furnishing of leased premises;
    3. personally made, arranged for, performed, or supervised repairs and maintenance to the property (whether or not performed by independent contractors), including without limitation painting, carpentry, and plumbing; and
    4. handled tenant repair requests and complaints.

Further, the ruling provides five examples that illustrate the application of Section 6166.  In example two, the decedent owned an office park and hired an unrelated property manager to handle most day-to-day activities relating to the management of the real estate.  The contractor and its employees provided all necessary services for the decedent’s office park.  In example four, strip malls were owned and managed through a limited partnership, of which the decedent was a limited partner.  The partnership, acting through its general partner, handled the day-to-day operations and management of the strip malls.  The activities of the general partner on behalf of the limited partnership included (either personally or with the assistance of employees or agents) performing daily maintenance of and repairs to the strip malls (or hiring, reviewing and approving the work of third party independent contractors for such work), collecting rental payments, negotiating leases, and making decisions regarding periodic renovations of the strip malls.

With respect to example two, the IRS determined that, because the decedent, who owned no interest in the independent contractor, was not involved in the management or oversight of the property, the office park did not appear to be an active trade or business.  On the other hand, with respect to example four, the limited partnership’s management by a general partner and its employees was imputed to the decedent.  Accordingly, as described in the ruling, although the activities of an employee are imputed to the decedent, the activities of an independent contractor are not.

III. Qualification and deferral—passive assets

As a corollary to the rule that only an active business may qualify for Section 6166 deferral, the value of the business’s passive assets are not taken into account for purposes of meeting the 35 percent qualification test.  Further, such passive assets are disregarded when determining the amount of tax that can be deferred under Section 6166(a)(2).

Accordingly, when preparing an estate planning estimate for a client, the balance sheet of the client’s closely held business must be carefully examined to determine which assets are considered passive assets for purposes of Section 6166.  The retention of raw land, personal use assets, or other assets that bear no relation to the business will be considered passive assets.  Reducing the value of the business by the value of these passive assets will not only reduce the amount of the estate tax that qualifies for Section 6166 deferral, but may jeopardize Section 6166 qualification for the estate depending on the value of such assets.  Finally, if the client wishes to have greater certainty regarding the estate’s qualification for Section 6166 deferral or the computation of such deferral, the client may want to consider segregating his or her personal assets from business assets, and titling such assets accordingly.

IV. Business structure and subsidiaries

Generally, under Section 6166, stock held by one corporation in another corporation is deemed a passive asset.  Accordingly, if a client owns a corporation with several corporate subsidiaries, the majority of the parent company’s assets (stock in the subsidiaries) may be deemed passive, rendering Section 6166 deferral unavailable to the estate.  Section 6166 provides two exceptions to this general rule.

First, under Section 6166(b)(8), an estate may make a holding company election if the holding company does not carry on an active business, but its subsidiaries carry on active businesses.  However, by making this election, neither the five-year time period for deferral of estate tax payments nor the preferential 2 percent interest rate on a portion of the deferred estate taxes is available.

Second, under Section 6166(b)(9)(B)(iii), if both the parent company and its subsidiary are active businesses, meaning that 80 percent or more of the value of the assets of each corporation is attributable to assets used in carrying on its trade or business, then such corporations are treated as one corporation for purposes of Section 6166(b)(9)(B)(ii).  Unlike Section 6166(b)(8), if Section 6166(b)(9)(B)(iii) is relied upon to qualify for Section 6166 deferral, no benefits are lost.  However, the 80 percent test may be difficult to meet.

Many estates simply cannot meet the Section 6166(b)(9)(B)(iii) test, and other estates either may not qualify under Section 6166(b)(8) or do not wish to accept the reduced benefits of that provision.  To avoid the application of these rules, the client should consider converting the subsidiaries of a closely held business from corporations to single-member LLCs.

If the entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch, or division of the owner.

When feasible, a client should consider structuring a business through the use of single-member LLCs rather than wholly-owned corporate  subsidiaries to avoid any traps associated with stock being deemed a passive asset for purposes of Section 6166.  By converting subsidiaries to avoid any traps associated with stock being deemed a passive asset for purposes of Section 6166.  By converting subsidiaries from corporations to LLCs during the client’s lifetime, the owner of a closely held business may enable his or her estate to qualify for Section 6166 deferral.

 

[1]  PLR 200521014; PLR 200518011; Rev. Rul. 75-365; 1975-2 C.B. 471 (revoked by Rev. Rul. 2006-34); Rev. Rul. 75-367, 1975-2 C.B. 472 (revoked in part by Rev. Rul. 2006-34).

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