October 2009 ESTATE PLANNING. Funding Estate Liquidity: The 6166 Election and Life Insurance RANDY L. ZIPSE, ATTORNEY, AND LINA R.

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1 ESTATE October 2009 PLANNING Funding Estate Liquidity: The 6166 Election and Life Insurance RANDY L. ZIPSE, ATTORNEY, AND LINA R. STORM, CLU, CHFC

2 Funding Estate Liquidity: The 6166 Election and Life Insurance Even if an election is made under Section 6166 to defer the payment of estate tax on a closely held business interest, the purchase of a life insurance policy will often be a tax-efficient complement to the Section 6166 election. RANDY L. ZIPSE, ATTORNEY, AND LINA R. STORM, CLU, CHFC An estate made up of a closely held business may elect to defer the estate taxes payable through the use of an installment loan arrangement governed by the rules of Section Although this statutory deferral option allows an estate with a large portion of its assets in a closely held business the convenience of time to generate liquidity to pay estate taxes, careful consideration should be given to the specific rules for Section 6166 qualification. Moreover, consideration should be given to the circumstances under which collateral is required to secure the deferral, as well as to the additional liquidity necessary to fund estate taxes due on the balance of the estate assets that cannot benefit from the Section 6166 deferral provisions. Finally, a cost sensitivity analysis is necessary to compare the deferral election to the discounted liquidity that the current purchase of a life insurance policy may provide. Alternatively, even when an estate will qualify for the 6166 election, further deliberation should be given to the net costs of funding a life insurance policy as a complement to a future Section 6166 election, especially when taking into account that the deferral of tax under Section 6166 comes with the obligation to pay, even in declining market conditions when the value of the business or its cash flow may have dropped significantly. The mechanics of the Section 6166 election The installment election under Section 6166 is available to the estate of a U.S. citizen or legal resident if RANDY L. ZIPSE, of the Iowa, Texas, and Missouri Bars, is Vice President and Senior Counsel, Advanced Markets, with John Hancock Financial in Boston. He is also co-author, with Stephan R. Leimberg, of Tools and Techniques of Charitable Planning. His e- mail is rzipse@jhancock.com. LINA R. STORM, CLU, ChFC, is Marketing Director of the Advanced Markets Group with John Hancock Financial Services in Boston. She also has an MBA degree. Her is lstorm@jhancock.com. The authors have previously written and lectured on estate planning. 27 the value of the interest in the closely held business 2 accounts for more than 35% of the adjusted gross estate, defined as the value of estate assets reduced by allowable deductions. 3 Allowable deductions generally include debts, estate administration costs, liens, and mortgages. To take advantage of estate tax deferral under this section, the estate must file an election within nine months of death, or no later than a timely-filed estate tax return. Definition of a business interest under Section Generally, a business interest is defined under Section 6166(b)(1) as (1) an interest as a sole proprietor; (2) a partnership interest if either 20% or more of the total capital interest in such a partnership is included or the partnership had 45 or fewer partners; or (3) stock in a corporation if either 20% or more of the voting stock is included or the corporation had 45 or fewer shareholders. In all cases, qualification

3 28 requires that the business interest be an actively operating trade or business. Consequently, passive ownership interests do not qualify. The level of activity of the deceased owner generally distinguishes an active business that qualifies for the election from nonqualifying passive ownership. 4 In some cases, as with holding company stock, for example, although the business interest may qualify for Section 6166 treatment under certain circumstances, the favorable terms of the election, such as the low rate of interest and the terms of the deferral period, may not be available or may be significantly limited. 5 Qualification under Section Under Section 6166, the estate would elect to defer payment of estate taxes due on the proportional value of the business. That is, the Section 6166 election will apply only to the tax owed on the value of the closely held business not to the tax owed on the value of the entire estate. Although gifts of certain business interests made within three years of death will be considered for the 35%-of-adjusted-gross-estate test, having these gifts brought back into the estate for purposes of Section 6166 qualification may result in additional taxes under Section 2035(a). Moreover, due to a variety of possible circumstances, special rules apply to the 35% test, including cases in which the business is structured as a sole proprietorship, when ownership in more than one business is permissible, or when the business is a farm, for example. 6 With regard to businesses that lease property, it may be more difficult to accurately assess in advance whether or not corporations that rent property to those corporations that were also owned by a decedent will qualify for the Section 6166 deferral. 7 The IRS generally relies on the facts and circumstances of the business operation when determining whether or not leased real estate qualifies as an active trade or business. The loan terms of Section The terms of the installment loan provided for under Section 6166 appear to be quite favorable relative to the structure of typical installment notes. Section 6166 allows the estate to delay by up to five years the payment of taxes attributable to a qualifying business interest, and then permits the estate to pay such taxes in up to ten equal installments after the deferral, providing a total of up to 14 years of deferral. 8 Because the first installment of tax is due at the An estate requires timely liquidity to fund the portion of the tax that does not benefit from the Section 6166 deferral. same time as the last installment of interest, the total possible payment period is 14 years, and not 15. However, the deferral is applicable only to estate tax due on the business interest and not to the interest payments on the deferral, which are required to be paid annually. The first $1,330,000 million in 2009 (indexed for inflation) of the business s taxable value incurs interest throughout the installment period at a rate of 2% and is known as the 2% portion. 9 Therefore, in 2009 the amount of estate tax attributable to the business interest that may benefit from the favorable 2% rate is capped at $598,500. Taxable value exceeding the 2% portion incurs interest at 45% of the current regular tax underpayment rate, which changes quarterly and has averaged approximately 8.5% historically. 10 For individuals and small corporations, the applicable underpayment rate is calculated based on the short-term applicable federal rate ( AFR ) plus three percentage points, rounded up to the nearest full percentage. Notably, interest paid under a Section 6166 arrangement does not qualify as an administrative expense and is not deductible on either the estate tax return or the fiduciary income tax returns. The Section 6166 election does provide an estate with savings from the deferral, as well as a bargain rate of interest. However, there are provisions in this section that apply regardless of market conditions and may even trigger acceleration of the deferred tax. Thus, when a Section 6166 election is made, the deferred taxes must be paid even in poor market conditions when the value of the business may be declining or the business may be forced into bankruptcy. If the business cannot meet its cash flow needs and the source of funds for the Section 6166 payments is cash flow from the business, the estate may likely default on its payment obligations. As a result, an acceleration of the deferred tax may be triggered. In this case, the two immediate options may be to use other estate assets to fund the payments, or for the beneficiaries to fund the deferred tax payments. Although beyond the scope of this article, bankruptcy raises complex issues regarding IRS liens, and beneficiary transferee liability may need to be addressed. Given the spirit of this section, however, it is likely that the estate and beneficiaries may work with the bankruptcy trustee and the IRS to seek relief, or to establish a more feasible payment plan. Regarding the prospect of acceleration of the deferred tax, OCTOBER 2009 VOL 36 / NO 10 ESTATE LIQUIDITY

4 29 EXHIBIT 1 Hypothetical Case: Assumptions Tax Year 2009 Profit Margin 10% Underpayment Rate (ʻGoing Rateʼ) 8% 2009 Maximum 2% Amount $598, Net Taxable Estate $8,000, Value of Business $4,000,000 Estate Tax Method 2009 Limits Payments per Year Daily Payment Period End of Year Net Present Value Rate 5% Estate Growth Rate 3% Life Insurance Survivorship Policy Premium $98,467 annually Death Benefit $10,000,000 Business Owners: Married Couple Male Age 64 / Female Age 61 although a change in the structure of the business will not necessarily accelerate the taxes due, 11 if 50% or more of the business is exchanged, sold or distributed, the payment of the unpaid deferred taxes may be accelerated. 12 Generally, an acceleration of taxes will also occur when a subsequent transfer by the beneficiary of the closely held business is made to a nonfamily member who is not involved in the business. 13 Nevertheless, subsequent transfers of the business interest to family members actively taking part in the business operations, 14 or an exchange of estate assets for partnership interests generally will not accelerate taxation. Moreover, Section 6166 does not reduce the estate taxes payable. Although Section 6166 helps to temporarily relieve the burden of paying the tax, the deferral does not apply to the taxes attributable to the other assets in the taxable estate. Therefore, the estate requires timely liquidity to fund the portion of the tax that does not benefit from the deferral. Further on the point of liquidity, although the funding of Section 6166 installment payments can be coordinated with a series of stock redemptions that qualify under Section 303 as tax-free withdrawals from a closely held corporation, 15 reconciling the rules of Section 303 with Section 6166 can be difficult with respect to timing the redemptions and the installment payments to avoid an unexpected acceleration of the deferred estate tax. 16 Moreover, even when the planning is structured properly to optimize the benefits of each respective Code section without running afoul of the rules, serious consideration must be given to the unnecessary use of the business to fund estate liquidity at the business owner s death a time when the business may not be in a position to provide the funding, especially if market conditions are not optimal or are in a state of change. Another limitation of Section 303 is the fact that the debt obligations of the estate cannot be funded through stock redemptions if taxfree treatment of the redemption is desired. These situations further highlight the estate s need for tax- free liquidity at the death of a business owner. Although the liquidity needs of the estate can be reduced during the business owner s lifetime through commonly-used planning strategies that minimize exposure to transfer taxes, such as the implementation of a Note Sale of closely held business interests to a grantor trust that benefits family members involved in the business, these techniques can disqualify the estate from being eligible to make the Section 6166 election. That is, the debt from the Note Sale will be includable in the estate and will not be a part of the business interest for purposes of the 35% test. Notably, the IRS has begun to call attention to the bond or lien requirements of Section 6166, which it may seek to exercise not only against the business itself but also against the underlying assets of the business. Although formal Regulations from the Service are still pending, the IRS determines on a case-by-case basis whether or not a surety bond from the estate, or a special lien under provisions of Section 6324A is required. 17 Moreover, a surety bond may prove to be prohibitively expensive, or may be unavailable. Again, the added burden of a lien on the business at the time of an owner s death may negatively affect the business s future ability to borrow, may subsequently burden its ongoing operations, and may compromise the business s ability to succeed to the next generation. Although there are benefits to taking advantage of the Section 6166 election, certain aspects of the tax deferral and installment payments under this election make life insurance an extremely attractive complement, or even an alternative, to the use of Section ESTATE PLANNING OCTOBER 2009 VOL 36 / NO 10

5 30 EXHIBIT Installment Payments Based on Year 2033 Joint Life Expectancy* Year of Death 2033: First Death Age 81 / Second Death Age 85 The benefits of life insurance Life insurance provides needed flexibility and performs a variety of important functions. First, a life insurance policy, especially a policy with guaranteed premiums and death benefit, is self-completing, providing the estate with cash when it needs it most. Second, the life insurance provides the estate with the liquidity it needs to meet all its estate tax obligations, not only those that qualify for tax deferral and installment payments under Section Third, when life insurance proceeds are available, there is no need to identify additional sources of funding. More significantly, there is no need to divert cash away from the business to fund a tax bill that is not reinvested in the growth of the business. Fourth, the payment of premiums currently will reduce the size of the taxable estate, while creating estate liquidity. Finally, the availability of life insurance proceeds eliminates the concern and anxiety of preparing the business today to fund tomorrow s estate tax bill. Scenario 1 Taxable Estate $16,262,353 Value of Business $8,131,176 Adjusted Gross Estate $16,262,353 Minimum 35% of Adjusted Gross Estate $5,691,823 Net Federal Estate Tax $7,198,859 * Joint Life expectancy is based on the 2001 Valuation Basic Table The following example helps illustrate the relative cost to the estate in terms of the present value of dollars spent when considering four basic planning scenarios. Each of the four scenarios is based on the same projected year of death against a range of assumed factors, including a given rate of inflation and a given rate of estate tax. Scenario 1. In the first of these options, no planning has been done, and it is assumed that the estate taxes calculated are payable within nine months of death. This scenario does not take into account the source of the funding. Scenario 2. The second option assumes that the client s business assets qualify for an election under Section 6166 for estate taxes attributable to the business interest paid over the maximum allowable installment period of 14 years. This scenario does not take into account the funding source of the Section 6166 installment payments or the balance of the estate taxes payable that do not qualify for deferral under Section Scenario 3. The third option illustrates the current purchase of a life insurance policy to pre-fund the full estate tax payable, regardless of Section 6166 qualification and the feasibility of a Section 303 stock redemption. Scenario 4. The fourth option illustrates the use of a Section 6166 election to defer taxes in conjunction with the purchase of a life insurance policy to provide the estate with liquidity and flexibility. Hypothetical sample case analysis Exhibit 1 provides a summary of the assumptions used in this case. James (age 64) and Mary (age 61) Baker, a married couple, are considering the options available to pay their expected estate tax bill. They have a business that represents 50% of their adjusted gross estate. Exhibit 2 shows what the values of the estate and business are, assuming a growth rate of 3%, and illustrates what the corresponding estate taxes are projected to be in Year 2033, their assumed joint life expectancy. This information is sufficient to assess Scenario 1 above, in which it is assumed that no plan has been put in place to fund the cash needed to pay estate taxes. Scenario 1. As the calculations in Exhibit 2 indicate, the estate tax due, based on current estate tax law, is $7,198,859. In today s dollars, assuming 5% time value of money, this amounts to $3,865,169. (See Scenario 1 in Exhibit 4 for a summary of the calculations that correspond to the Scenario 1 assumptions.) What this means is that approximately $7.1 million is required in cash immediately, or through the liquidation of assets, to fund the projected estate tax liability, if an election under Section 6166 is not made. The election may OCTOBER 2009 VOL 36 / NO 10 ESTATE LIQUIDITY

6 31 EXHIBIT 3 Summary Calculation With 6166 Election: Year 2033 Year of Death 2033: First Death Age 81 / Second Death Age 85 Estate Tax That Must Be Paid Currently (A) $3,599,429 Estate Tax That Can Be Deferred $3,599,429 Unified Credit $1,455,800 2% Amount: ($598,500 indexed at 3%) $1,215,000 Amount of Tax at ʻGoing Rateʼ $2,384,429 ʻGoing Rateʼ (45% of Underpayment Rate) Changes Quarterly 3.6% Total Interest $1,159,819 Total Deferred Principal $3,000,929 Total 6166 cost (B) $4,759,249 Total Estate Tax Cost (A + B) $8,358,678 not be available because either the Baker estate no longer qualifies for it, or the lien requirements and/or the drain on the business s cash flow to fund the installment payments make the election prohibitive. Scenario 2. Next, the Bakers look at Exhibit 3, which illustrates the math behind the costs of a Section 6166 election made in They then turn their attention to Scenario 2 of Exhibit 4 to find the present value of the Section 6166 cost of the annual payments, assuming the installment payments begin at life expectancy, or year 2033, and last for 14 years. The present value figure is $6,935,467. This translates to a cost of $3,723,750 in today s dollars. By making the Section 6166 election in 2033, the Baker estate will decrease its overall estate tax liability over Scenario 1 by $141,419 on a present value basis. However, in this scenario, the estate is still required to come up with the cash to pay for the approximately $3.6 million of additional estate taxes due on the assets that do not qualify for deferral under Section Furthermore, the business would have to earn, on a pre-tax basis, an income of 16.83% to fund only the Section 6166 payments over the 14- year installment period, assuming a 40% corporate income tax rate and a 10% profit margin. The balance of estate taxes payable is not With life insurance, there is no need to divert cash away from the business to fund a tax bill that is not reinvested in the growth of the business. taken into account in this return figure. The pre-tax income figure is arrived at by averaging the cumulative installment payments of $4,759,249 over the 14-year installment period, for an average annual payment of $339,946. This average payment represents over 4% of the business valued at $8,131,176 in 2033 (see Exhibit 2). Scenario 3. This brings the discussion to Scenario 3 in which the Bakers consider the cost-effectiveness of purchasing a life insurance policy today to fund the entire estate tax bill at discounted dollars instead of at an interest cost under the government s Section 6166 installment plan. When the Bakers look at the cost of a $10 million survivorship life insurance policy, they see that Scenario 3 in Exhibit 4 calculates the total cost as a gain of $1,954,979, taking into account any excess death benefit above the estate tax liability, while netting out the current cost of premium payments and any applicable gift taxes. In today s dollars, the present value cost is $83,541. Note that the gross estate is reduced by the amount of the annual premiums, and any growth that would have accompanied the premium amounts inclusion in the estate. Therefore, the total estate tax liability from Scenario 1 has been reduced, in this scenario, by $1,615,522, because of annual premiums paid from the estate ($7,198,859-$5,583,337). Scenario 4. The final scenario in Exhibit 4 indicates that there is in fact a gain over Scenario 3 if both a Section 6166 election is made (assuming the Bakers still qualify), and if life insurance is purchased to fund the taxes. The gain over the stand-alone life insurance option is $221,210 ($2,176,189 $1,954,979). In this combination plan, the purchase of the life insurance policy provides the estate with a significant degree of flexibility as well as the convenience of time to assess all available options at the time when the estate taxes are actually due. Conclusion By making a timely election under Section 6166, an estate may enter into an interest-only loan arrangement with the IRS to defer ESTATE PLANNING OCTOBER 2009 VOL 36 / NO 10

7 32 EXHIBIT 4 Cost Analysis of Each Option in Year 2033 temporarily the payment of estate taxes payable at the death of a business owner of a closely held entity. This provision of the Code was established to help successful businesses succeed to the next generation without the burden of being liquidated to fund the taxes. However, it may be more costefficient to pay estate taxes through the purchase of a life insurance policy at discounted dollars today. This approach will provide heirs with the liquidity needed to fund the estate tax bill. Even if the deferral election is made by a qualifying estate, the purchase of a life insurance policy will often be a tax-efficient complement to the election under Section Life insurance supplies the estate with the liquidity it needs exactly when it is needed and eliminates uncertainty about how the future tax obligation will be funded. And, while premium payments are made during the business owner s lifetime, they have the added The cash from the insurance policy eliminates the need for a forced sale of the business or its assets to meet the tax obligation. benefit of reducing the taxable estate. Moreover, the cash from the policy proceeds eliminates the need for a forced sale of the business or its assets to meet the tax obligation. While it is important to conduct a cost-benefit analysis comparing the net costs of both a Section 6166 election and the purchase of a life insurance policy, consideration of the risk of not qualifying for Practice Notes An election under Section 6166 comes with the obligation to pay the deferred tax, even in declining market conditions when the value of the business or its cash flow may have dropped significantly. the Section 6166 election in the future must be taken into account. Furthermore, the limitations on future planning options that result from making the election as well as the potential for the acceleration of the deferred taxes in certain situations make the Section 6166 election a problematic proposition as a stand-alone planning option. Finally, the declining value of a closely held business in poor market conditions may be particularly burdensome when taxes are deferred under the Section 6166 government loan arrangement. OCTOBER 2009 VOL 36 / NO 10 ESTATE LIQUIDITY

8 1 For a comprehensive analysis of Section 6166, see Blattmachr, Gans, and Madden, Untangling Installment Payments of Estate Tax Under Section 6166, 36 ETPL 3 (July 2009). 2 Section 6166(a). See Ltr. Rul See Section 6166(b)(6). 4 The IRS views the level of the interest-holder s activity as the significant factor in determining if the tax deferral benefits of Section 6166 are available to the estate. 5 See Sections 6166(b)(1)(C) and 6166(b)(8). Also see TAM See Ltr. Rul See Rev. Rul , CB Sections 6166(a)(3) and 6166(f). 9 See Section 6601(j). For deaths in 2009, the maximum amount of tax that is eligible for the 2% treatment is $598,500. This amount equates to taxes on the first $1 million of taxable value, indexed for inflation. The indexed amount specific to Section 6166 is $1,330,000 in Calculated based on the average of the applicable underpayment rates published since See Ltr. Rul See Section 6166(g). 13 See Section 6166(g)(1)(D). Also see Rev. Rul. 89-4, CB 298, regarding the sale to a nonqualified heir to avoid foreclosure of a farming entity. 14 See Section 267(c)(4). 15 See Sections See Ltr. Rul , amended by Ltr. Rul See also Reg A-3(d)(2); Rev. Rul , CB 356. Also see safe harbor rules under Section 6166(g)(1)(B). 17 See Estate of Roski, 128 TC 113 (2007), and Notice , IRB See also IRS Program Manager s Technical Advice (2/25/09) and IRS SBSE Memorandum SBSE (6/12/09). REPRINTED WITH PERMISSION WARREN, GORHAM & LAMONT OF TTA ESTATE PLANNING OCTOBER 2009 VOL 36 / NO 10