How to Defer Inheritance Tax on Business Interests
If you’re a small business owner, you may have spent years or even decades building a successful business. You now hope to enjoy the fruits of your labor as you approach retirement. But you may want to secure some estate protection for your highly valued business interests.
Currently, the generous estate tax exemption can shelter tax bequests of up to $10 million (indexed to $12.06 million in 2022), but that figure is expected to drop to $5 million (plus indexing) in 2026. Your family may therefore still face inheritance tax exposure in the future.
Practical solution: arrange things so that your executor elects Section 6166 estate tax relief. Under this provision, no tax is due on the business interest for five years and subsequent payments can be spread over ten years. Therefore, your family can take up to 15 years to pay the tax. (Due to the timing required for installments, the actual deferral period is 14 years.)
Sounds good, right? But there is a catch. Interest must be paid each year on the unpaid part of the tax. Fortunately, however, the estate only pays 2% of the tax attributable to the first million dollars of business ownership. The interest rate for tax underpayments applies to any amount over $1 million (subject to indexation for inflation). This threshold for 2022 is $1.64 million.
How does an estate qualify for Section 6166 relief? It’s not automatic. Specifically, the following three conditions must be met.
1. The deceased must have been a US citizen or US resident at the time of death.
2. The interest in the private business must comprise more than 35% of the adjusted gross estate of the deceased.
3. The election must be made by the estate’s personal representative on a timely filed inheritance tax return.
For the purposes of the 35% test, the calculation is based on subtracting certain deductions from the gross estate such as debts, funeral expenses, administration expenses, mortgages and liens. However, these deductions are taken into account before applying the available charitable and marital inheritance tax deductions.
Additionally, you must have operated the business as one of the following:
- A sole proprietor;
- A partner having an interest of 20% or more in the partnership, or having an interest in a partnership that has no more than 45 partners; Where
- A shareholder company holding 20% or more of the voting shares, or holding shares of a company with no more than 45 shareholders.
In conclusion: it’s a lot to consider, but the effort is worth it when you consider that the highest tax rate is 40%. If you qualify, meet with your estate and tax planner to arrange for Section 6166 relief. Your family will approve!