Overview
Normally, federal estate tax is due nine months after death. For estates that are illiquid, and that can include many taxable farm and ranch estates, there is an option that can come in handy. The estate executor can elect under I.R.C. §6166 to pay the federal estate tax in installments over (approximately) fifteen years. However, to make sure that the deferred estate tax is paid in full, the IRS can require a bond to secure payment of the deferred tax. The IRS can also require the executor to provide the IRS with a special lien as a condition of the IRS accepting the election. I.R.C. §6324A. But what if, during the installment payment period, the value of the assets in the estate drop below the remaining amount of tax due to the IRS and the executor hasn’t been fully paid? Does the IRS lien get paid first? If so, are there any planning steps that can be taken to ensure that the executor’s fee gets paid in full? That’s the focus of today’s post.
In General
If an installment payment election is made, interest only need be paid for the first five years after the due date for the federal estate tax return (which is nine months after the date of the decedent’s death) with the tax paid in two to ten annual installments thereafter with interest on the unpaid balance beginning 69 months after death. The maximum installment payment period is 177 months after death.
Interest at 2 percent (compounded daily) is imposed on the amount of deferred estate tax attributable to the first $1,480,000 in value of taxable estate attributable to a closely-held business for deaths in 2016. For deaths in 2016, the amount eligible is the federal estate tax attributable to a closely-held business between $5,450,000 and $6,930,000. If the estate holds an interest in a closely-held business of $6,930,000, the 2 percent portion would be $592,000 (the $2,717,800 estate tax on $6,930,000 minus $2,125,800, the credit for the applicable exclusion amount for 2016). To determine the amount of estate tax that can be deferred and paid in installments, the total estate tax (reduced by available credits) is multiplied by a fraction equal to the value of the closely held business interest divided by the value of the adjusted gross estate.
Eligibility Requirements.
Two eligibility tests must be satisfied for an estate to qualify for installment payment of federal estate tax. The first test, known as the Tier I test, requires that the decedent have an interest in a closely held business. I.R.C. §6166(a)(1). That means at least 20 percent of corporate voting stock or the corporation has 45 or fewer shareholders. The same percentage and number of shareholder applies with respect to partnerships. For sole proprietorships, the interest in the sole proprietorship counts. Land held in a revocable living trust continues to be eligible for installment payment of federal estate tax if it is a “grantor” trust. Also, land rented under a lease constitutes an interest in a closely held business if it is a crop share lease or a livestock share lease with active involvement in decision making by the decedent-to-be, or an agent or employee of the decedent-to-be. Passive rental arrangements, such as cash rent leases, are not eligible and deferred tax is accelerated if the value of assets involved (plus all distributions, sales or disposition of assets after death) equals 50 percent or more of the date-of-death value of the interest in the closely-held business which qualified for installment payment. For assets leased to business entities, the Tier I test is applied separately to the business entity and the leased assets.
In 2006, IRS clarified that, to be an interest in a trade or business under I.R.C. §6166, a decedent must conduct an active trade or business or must hold an interest in a partnership, LLC or corporation that itself carries on an active trade or business. Rev. Rul. 2006-34, 2006-1 C.B. 1171. In the ruling, IRS set forth a list of non-exclusive factors to determine whether a decedent’s interest is an active trade or business. The factors are: (1) the amount of time the decedent (or agents or employees) spent in the business; (2) whether an office was maintained from which the activities were conducted or coordinated and whether regular office hours are maintained; (3) the extent to which the decedent was actively involved in finding new tenants and negotiating and executing leases; (4) the extent to which the decedent provided landscaping, grounds care or other services beyond the furnishing of the leased premises; (5) the extent to which the decedent personally made, arranged for or supervised repairs and maintenance on the property; and (6) the extent to which the decedent handled tenant repairs and requests.
The second test, known as the Tier II test, requires that the interest in the closely held business exceed 35 percent of the value of the decedent’s adjusted gross estate. I.R.C. §6166(a)(1). For a corporation, corporate stock of any kind, common or preferred, meets the requirement. In the Tier I test, only the voting stock counts. In the Tier II test, any stock can count. For a partnership, an interest in a partnership carrying on a business will count. In a sole proprietorship, the interest in the sole proprietorship will count towards the 35 percent test. Rental arrangements that meet the Tier I test will also meet the Tier II test. Thus, assets under an active lease arrangement may be applied toward the 35 percent amount.
For purposes of the 35 percent requirement, interests in residential buildings and related improvements which are occupied on a regular basis by the owner, tenant or an employee of the owner or tenant for purposes of operating or maintaining the property can be included. However, if the buildings have been carved out and occupied by someone working off the farm, it’s no longer a business asset. Acreage under the Conservation Reserve Program (CRP) or other federal acreage diversion programs apparently is eligible. Priv. Ltr. Rul. 9212001 (Jun. 20, 1991).
Points to Watch After Death.
If one-half or more of the interest in the closely-held business is distributed, sold, exchanged or otherwise disposed of or is withdrawn from the business, the remaining installments become due. Transfers involving the decedent’s interest in a closely-held business at the death of the original heir, or at the death of any subsequent transferee, do not accelerate federal estate tax payment if each subsequent transferee is a family member of the transferor. Therefore, while property can be left at death to a family member without violating the 50 percent requirement, property devised to non-family members always counts against the 50 percent test. Property sold or given away during life even to family members counts against the 50 percent test.
Mere changes in organizational form or tax-free exchanges of property do not accelerate installment payments. Apparently, mortgaging the property in the post-death period does not accelerate the payment if the funds are used to pay the costs of refinancing and liens. But, the only authority on this particular point consists of a few IRS rulings. While the use of funds received from mortgaging the property to pay the costs of refinancing and liens is not a very exciting way to refinance, it apparently is the only possibility for which there is clear authority except that property can be sold to pay indebtedness existing at death.
Cash renting is always considered a disposition. As a result, cash renting of assets during the 15-year installment payment period must be avoided. Similarly, a dividend payment is a disposition if it involves payment out of pre-death earnings and profits. That is a problem only with big dividend distributions out of earnings and profits that accumulated before death.
Bankruptcy will not itself count against the 50 percent requirement, but if there is any transfer after bankruptcy filing, it counts against the 50 percent requirement. Thus, one must always keep track of one’s precise position with respect to closeness to the 50 percent mark.
The IRS Lien and Unpaid Executor Fees
As noted earlier, the IRS can require an estate executor to grant the IRS a special estate tax lien in accordance with I.R.C. §6324A in connection with an I.R.C. §6166 election to pay the estate tax in installments. In a recent case, United States v. Spoor, 838 F.3d 1197 (11th Cir. 2016), the executor’s fees had not been fully paid at the time the lien was granted. During the 15-year period, the value of the estate property subject to the IRS lien dropped below the amount due the IRS for unpaid estate tax. The executor claimed that he had a priority claim against the estate assets for the amount of his unpaid fee. The IRS claimed that it had a priority claim on the estate assets for the amount of the unpaid estate tax. The trial court granted the executor’s motion for summary judgment on the basis that the operative statute was silent as to the payment of administrative expenses. Thus, the trial court gave the executor’s claim priority on a “first in time, first in right” theory.
On appeal, the appellate court reversed. The appellate court reasoned that the executor’s claim for unpaid fees was not a lien and, as such, the trial court’s priority theory had no application. The appellate court then noted that I.R.C. §6324, the IRS general estate tax lien provision, does provide for administrative expenses to have priority over a government lien. However, the government’s lien in this case was a special lien under I.R.C. §6324A which did not provide any special rule for administrative expenses. The executor claimed that he should prevail on the basis that if his claim did not have priority it would be hard to find executors to serve. The court disagreed, and noted that the executor could have planned for payment before granting the IRS the special lien. The court pointed out that the executor could have granted the lien on less than all of the estate property, or not make the I.R.C. §6166 election, or simply make other arrangements to make sure the fee was paid. The appellate court also noted that if the IRS special lien were subject to administrative expenses, then partially unsecured deferred payment obligations under I.R.C. §6166 could result. Also, the court noted that the executor’s claim for unpaid fees would not have priority over any bond to secure the estate tax deferred under I.R.C. §6166 and, thus, should not be given priority over the IRS claim.
Conclusion
Installment payment of federal estate tax can be useful in those taxable estates that are characterized by a lack of liquidity. But, when estate values drop during the installment period, problems can arise. The Spoor case points out that the estate tax lien can beat out a claim for executor’s fees. But, with proper planning the executor can make sure that fees will get paid in full.