by Bob Rywick

A special estate tax deferral election is available if more than 35 percent of the value of an estate consists of a farm or other closely held business.

If the election is made for an eligible estate, payment of the estate tax will be deferred for up to five years and can then be paid off over a 10-year period. Interest on the deferred amount, subject to a limitation discussed below, is set at only 2 percent. However, payment of interest on the unpaid part of the estate tax is not deferred and must be paid annually.

Observation: This five-year deferral with 10-year installment extension is sometimes referred to as a “15-year extension.” However, the first annual installment is due no later than the end of the fifth year after the regular due date of the estate tax return, and the remaining installments are due annually on the same date after that. Accordingly, the maximum extension period is only 14 years after the regular due date.

Observation: Making the election often makes it possible to keep a closely held business in the family. In effect, all or a substantial part of the estate tax that is attributable to the closely held business can be paid out of the business’ earnings over a period of years after the decedent’s death. If the election were not available, the heirs might have to sell the business, or at least a substantial ownership interest in the business, to outsiders. To qualify to make the election, both a business interest test and a value test must be met.

The business interest test

To qualify for estate tax deferral, the business interest must be of a type that qualifies for the election. If the decedent was the sole proprietor of the business (or farm), then it was his business entirely and you can proceed to the value test described below.

However, if the decedent had partners, the deferral election can be made only if:

● There were no more than 45 partners in the partnership; or,

● At least 20 percent of the total capital interest of the partnership is included in the gross estate.

If the business was operated as a corporation, the deferral election can be made only if:

● The corporation had no more than 45 shareholders; or,

● The decedent owned at least 20 percent of the outstanding voting stock of the corporation.

In applying the 45-partner or 45-shareholder test, interests or shares owned by the decedent’s spouse, siblings, ancestors and descendants are treated as owned by the decedent. Also, any interest owned jointly by a married couple is counted as one partner or shareholder.

Example 1: Your client is the executrix of her father’s estate. At the time of his death, he owned 12 percent of the outstanding voting stock of a C corp that had 48 shareholders including the decedent, his two brothers and his daughter and son. Since, for purposes of the 45-shareholder test, the shares owned by the decedent, his children and his brothers are treated as owned by the decedent, the corporation is treated as having only 44 shareholders (48 less four [the two children and the two brothers]). Accordingly, the estate will be eligible to elect to defer payment of the estate tax if the value test is met.

In applying the 20 percent interest test, for both partnerships and corporations, the executor may elect to have the interests of these family members counted as the decedent’s interest. However, if this is the way the decedent’s interest qualifies for the deferral, then:

● The five-year deferral period is lost (i.e., the 10-year payment period starts right away); and,

● The favorable 2 percent interest rate is not available on deferred amounts.

Example 2: Your client is the executor of his mother’s estate. The value of the adjusted gross estate (defined below) is $4 million. Included in his mother’s estate is a partnership interest valued at $1.5 million (i.e., 37.5 percent of her adjusted gross estate). However, there are 70 partners in the partnership (none of whom are related to your client’s mother), and the estate has only a 12 percent interest in the partnership’s capital. Accordingly, the estate is not eligible to elect to defer payment of the estate tax.

Example 3: The same facts apply as in Example 2, except that your client and his sister each has a 5 percent interest in the partnership’s capital (the other 67 partners were unrelated to your client’s mother). If your client, as executor, elects, his 5 percent interest and his sister’s 5 percent interest will be combined with his mother’s 12 percent interest, so the 20 percent test will be met, i.e., the combined interest will be 22 percent. However, by making this election, the estate loses the five-year deferral period and the benefit of the 2 percent interest rate.

Observation: If the election described above is made, stock and partnership interests whose ownership is attributed to the decedent are treated as included in the estate solely for purposes of the 20 percent test. The value of those interests is not included in the estate for purposes of determining the amount of estate tax payable by the estate.

The value test

The value of the business interest must be more than 35 percent of the “adjusted gross estate.” The adjusted gross estate equals the gross estate less deductions for expenses, debts, taxes and losses.

For purposes of meeting the 35 percent test, two or more businesses in which the decedent had an interest can be combined and treated as a single business interest, if at least 20 percent of the total value of each business is included in the decedent’s gross estate

If a closely held business interest was held by the decedent and his wife as community property, as joint tenants, as tenants by the entirety, or tenants in common, the surviving spouse’s interest is treated as having been included in the decedent’s gross estate for purposes of determining whether the value test is met.

For purposes of determining whether the decedent had a 20 percent interest in an entity, the executor may make an election to attribute to the estate an interest in the business owned:

● Directly or indirectly by or for a corporation, partnership, estate or trust. If the election is made, the interest in the business is treated as owned proportionately by or for its shareholders, partners or beneficiaries. However, this rule applies to the beneficiary of a trust only if the beneficiary has a present interest in the trust.

<● By members of the decedent’s family, i.e., siblings (by the whole or half blood), spouse, ancestors and lineal descendants.

Observation: If the decedent and the decedent’s spouse own an interest in a business jointly, the spouse’s share is automatically treated as part of the gross estate for purposes of determining whether the 20 percent test is met. If the decedent’s spouse owns an interest in the business separately from the decedent, that interest is included in determining whether the 20 percent test is made only if the election described above is met.

Observation: Even if the election is made, the combined value of the decedent’s own interests in the two or more businesses must be at least 35 percent of the value of her adjusted gross estate.

Example 4: Your client is the executrix of the estate of her mother, who died on July 1, 2003. Her mother owned 15 percent of the voting stock of Thor Hammers Inc., and 12 percent of the voting stock of Zeus Electrical Supplies Inc. Your client owns, in her own right, 10 percent of the Thor voting stock and 8 percent of the Zeus voting stock. For estate tax purposes, the value of the 15 percent of Thor stock is $500,000, and the value of the 12 per­cent of Zeus stock is $600,000. The adjusted gross estate is $2.5 million. Accordingly, the value of neither stock by itself meets the 35 percent test, i.e., the value of the Thor stock is only 20 percent of the adjusted gross estate, and the value of the Zeus stock is only 24 percent. However, their combined value would be 44 percent of the adjusted gross estate ($1.1 million of 2.5 million).

If your client, as executrix, elects to combine her voting stock in the two corporations with the voting stock owned by the estate, the required 20 percent interest in each corporation will be met (a 25 percent interest in Thor and a 20 percent interest in Zeus). Since the value of the stock in the two corporations owned directly by the estate is more than 35 percent of the adjusted gross estate, your client may elect to defer payment of the estate tax attributable to the value of the stock owned by the corporations.

Determining the amount of the estate tax that qualifies for deferral. If the above tests are met, the part of the estate tax allocable to the qualifying business interest may be deferred. The amount allocable to the qualifying business interest equals the same percentage of the total net estate tax (i.e., the estate tax after applicable credits, such as the unified credit) that the value of the qualifying business(es) is of the adjusted gross estate.

Example 5: The same facts apply as in Example 4. Assume the net estate tax is $680,000 (gross estate tax of $1,025,800, less unified credit of $345,800). Since the combined value of the closely held business interests is $1.1 million, or 44 percent of the adjusted gross estate of $2.5 million, your client may elect, as executrix, to pay 44 percent of the estate tax in installments. Thus, she can elect to pay $299,200 of the estate tax in installments.

Determining how much of the deferred tax qualifies for the 2 percent interest rate. In 2003, the 2 percent interest rate only applies to the lesser of the the estate tax allocable to the closely held businesses, or the part of the deferred estate tax that is attributable to the first $1.12 million in taxable value of the closely held business(es).

The first $1.12 million in “taxable value” of the business is the first $1.12 million above the applicable exclusion amount ($1 million in 2003). The tax on this first $1.12 million is $493,800 (after deducting the unified credit). The interest rate on the deferred estate tax attributable to the taxable value of the business in excess of $1.12 million is reduced to an amount equal to 45 percent of the tax generally applicable to underpayments of tax.

Example 6: The same facts apply as Example 5. Since the estate tax allocable to the closely held business interests is only $299,200, or less than $493,800, the 2 percent interest rate will apply to the entire amount of the estate tax that is deferred.

Observation: The interest rate on underpayments for the fourth quarter of 2003 and the first quarter of 2004 is 4 percent. Since 45 percent of 4 percent is 1.8 percent, the interest rate on deferred estate tax attributable to the taxable value of a closely held business in excess of $1.12 million should only be 1.8 percent for those periods, or less than the 2 percent interest rate on the value up to $1.12 million. The interest paid on the deferred estate tax is not deductible for estate or income tax purposes.

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