Section 6166: How You Can Defer Estate Tax

Do you have clients who own a business or have just recently inherited one? When it comes to estate planning for business owners, understanding section 6166 of the US tax code could make a big difference in ensuring continuity of the business after the owner passes away.

While there are several estate planning strategies that can help clients reduce their overall estate tax bill, those who own a business should also be aware of strategies to defer payments on estate taxes to keep their heirs from having to do a fire sale of the business just to pay taxes.

So let’s take a look at what section 6166 is and how your clients can use it to transfer their business interests after death without liquidating a portion of the business unnecessarily.

What is section 6166?

Within the United States Internal Revenue Code (IRC), there is a section included to help people defer the payment of estate taxes when the estate includes business interests. This is known as section 6166 or IRC 6166

Since the value of a business counts towards an individual’s taxable estate, it means that when the business owner passes away, a large amount of estate taxes may be due. The exact amount of estate taxes due will depend on how much of their estate and gift tax exemption the decedent has left. 

If the value of the business is at least 35% of the adjusted gross estate, clients might be able to take advantage of section 6166 to spread the payment of estate taxes out over several years so that the whole payment doesn’t have to be made within 9 months of the decedent’s death. 

When is section 6166 most commonly used?

Section 6166 is mainly used when a person dies and leaves a family business as part of their inheritance. The normal estate tax payment rules require payment within 9 months of the decedent’s death. This may force the beneficiaries to sell part of the business or other assets at an inopportune time to pay the estate tax bill. 

When the value of the company constitutes a significant part of the total assets of the estate and paying taxes on the estate puts the continuity of the business at risk, section 6166 can help.

However, there are some criteria that must be met in order for the estate to take advantage of section 6166 which we will discuss shortly.

How long can you defer estate taxes for?

Section 6166 allows the estate tax associated with the value of the closely held business to be deferred for up to 14 years and 9 months after the date of death. Compare that to the ordinary rule which is 9 months after the date of death. When electing section 6166, the executor has the option to choose the initial installment payment date, which can be up to five years after the original due date of the tax. 

After your client pays the first installment of the tax, the remaining installments must be paid at least annually, starting no later than one year after the last payment. It’s important to make each installment payment on time because if a payment is missed by six months or more, this can accelerate the payment of all remaining deferred estate tax.

While section 6166 allows for the deferment of estate taxes, it does not defer the payment of interest that is due on these installment payments. According to section 6166, the interest on the deferred taxes must be paid at least annually.

Criteria for using section 6166 to defer estate taxes

When an individual passes away, their personal representative or executor must file Form 706 for the estate tax return within nine months from the date of death. To utilize the 6166 estate tax deferral, the person filing the return will need to make required statements to show that the estate qualifies for this election.

The criteria that determine if the estate qualifies for section 6166 include:

  • The decedent must have been a US citizen or US resident.
  • The business interest must be a closely held business interest in one or more companies.
  • The value of the closely held business interests of the estate combined must be at least 35% of the adjusted gross estate.
  • The executor must file Form 706 on time (within nine months of decedent’s death) and properly make the section 6166 election.

Before outlining how to file the section 6166 election, there are a few key terms that are important to define so that you or your client can do the calculations needed to ensure eligibility for section 6166. What exactly is a closely held business interest? And what all goes into the calculation of the adjusted gross estate? Let’s take a look.

Defining a closely held business interest for section 6166

When it comes to calculating the value of the business in proportion to the adjusted gross estate, here are a few guidelines to keep in mind to ensure the business meets the “closely held business interest” criteria.

A closely held business interest is defined as one where the owner is either the sole owner or, if the business is structured as anything other than a sole proprietorship, actively involved in the business. Passive assets are not allowed to be included in the calculation of active and closely held business interests.

If the business is structured as a partnership or a corporation, then the business value must make up at least 20% of the value of the deceased’s estate or the company has to have a maximum of 45 shareholders.

If the decedent owned more than one business, then the value of those business interests together must amount to at least 35% of the estate while still meeting the criteria above of each business making up at least 20% of the value of the estate. 

For example, if the decedent had an estate of $100 million and had two businesses worth $25 million each, then they would likely qualify for section 6166 as each business accounted for 25% of the estate separately and the combined value of those business interests was 50% of the estate. However, if each business was worth $10 million, then the estate would not qualify as each business was worth less than 10% of the overall estate and only 20% of the estate combined.

Defining the adjusted gross estate

Another term that is important to know in understanding how to use section 6166 to defer estate taxes is the adjusted gross estate. The adjusted gross estate serves as the basis for determining whether the value of the closely held business owned by the estate meets the 35% threshold.

The adjusted gross estate is calculated by starting with the gross estate, which includes all assets and property owned by the deceased at the time of their death, and then subtracting allowable deductions such as funeral expenses, debts owed by the deceased, and certain administrative expenses related to settling the estate.

It’s also important to note that while the standard valuation of the estate is based on the date of death, there are also cases where alternate valuation methods could be used by using section 2032 or 2032A of the tax code. 

After calculating the adjusted gross estate and getting a valuation for the business, you can then do the math to see if the business interests in the estate meet the 35% criteria for filing section 6166. If alternate valuation methods are used, those values should be used to meet the percentage requirements.

How to file section 6166 on an estate tax return

Filing section 6166 is done through the estate tax return form 706. The personal representative or executor who is filling out the tax return for the estate should check “Yes” under part 3, question 3 of Form 706. 

Additional documentation and statements should be attached to confirm that the estate meets the criteria for using section 6166 to defer the payment of taxes. The IRS instructions for attaching these statements are detailed on pages 14-16 in Instructions for Form 706.

The IRS has the discretion to approve or deny applications for section 6166 so it is not guaranteed that simply by applying, the estate will be granted this election. Also, note that in some cases, the IRS may request a bond to ensure payment of the tax. 

Considerations for business owners who wish to defer estate taxes

If your client wants to use section 6166 to defer their estate taxes, one of the most important considerations to take into account is the valuation of the business. It’s best to hire a qualified professional such as an independent appraiser to value the business and the estate assets so that the 20% and 35% calculations can be made with confidence.

If you have business owner clients who are just starting the estate planning process, it’s important to ask about the value of the business in relation to the estate to determine if their estate would be eligible for section 6166. Use our estate planning checklist for financial advisors to help you ask the right questions and ensure you don’t miss any important data as you guide your clients in leaving their desired legacy.

To further simplify estate planning for your clients, consider using estate planning software like Vanilla to help them visualize the flow of their assets after their death so they can take advantage of opportunities to prepare and plan ahead of time to minimize estate taxes and pass on the maximum amount of wealth to their heirs. 

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