WEALTH TRANSFER
Paying Estate Taxes by Borrowing
from Uncle Sam Has Gotten Harder

BY MATT DONOVAN

Many family businesses are counting on Sec. 6166 of the Internal Revenue Code to help them pay their estate taxes. It may be a mistake. Sec. 6166 is a provision that permits the estate of a deceased family business owner to pay estate taxes over a 14-year period. In years 1-4, you pay interest only (at 2%), and then you take 10 more years to pay off the tax due at a variable rate that is currently at 2.25%. Sounds like a pretty good deal, right?

The IRS recently has toughened the terms of its loan plan. Permanent repeal of the estate tax, which is scheduled to vanish in 2010 but reappear the following year, is looking unlikely. So the new rules may cause big problems for heirs looking for relief in paying estate taxes on estates worth $1 million or more.

Old Rules Still Apply
To be eligible for Sec. 6166, the "old" rules still apply:

1. the decedent's interest in the closely-held business has to be greater than 35% of the adjusted gross estate;
2. the business has to be an operating business (as opposed to something like passive investments in real estate), and
3. the estate tax deferred is the percentage that the business bears to the whole estate. For example, if the value of the business equals 70% of the estate, you can only defer 70% of the estate tax. But who wouldn't elect to defer some of their estate taxes, especially if the deal is better than some of the recent credit card promotions you've been getting? Unlike the credit card promotions, however, the IRS now wants security for their "loan."

Now the IRS is acting more like a bank. But not just any bank. This bank wants to be in a senior position. While heirs still can get generous rate and payment terms, they must be prepared to put up some hefty security. One option—to post a surety bond for twice the taxes owned—is prohibitively expensive. The second choice is an IRS lien on heirs' assets, most likely the business itself, for the tax due plus four years' interest.

There are additional new restrictions. Your heirs must agree with the installment plan. The IRS won't okay the plan if one of the business's new owners balks at the lien. And they must be committed to keeping the business running throughout the 14-year plan.

Banks May Balk
If the business has lines of credit or other bank loans, it means existing banks will have to subordinate (i.e. take a "junior" or secondary position) to the government. No bank will want to do that without:

• changing the terms of their loan and/or
• asking for additional collateral.

It's a Murphy's Law conundrum. If existing banks want their fines/loans paid off, the heirs will be in an even worse situation. But without existing banks subordinating to the government, the family may not be able to pay estate taxes due. Besides complicating future financing, the installment plan imposes a cash-flow burden on the business.

As our clients and most advisors know, creating a plan to pass the business to new owners before the owner's death can be structured to limit the tax bite. If the plan still leaves business value in the estate, a life insurance policy in a trust owned by the heirs can produce the cash to pay taxes without forcing a sale or borrowing.

Keeping the family business in the family never was easy. With the new IRS rules on financing estate taxes, one more complication has been added.