For 2024, the federal lifetime gift and estate exemption is $13.61 million ($27.22 million for married couples). With the generous lifetime exemption currently in effect, most families needn’t worry about getting hit with large federal estate tax bills. That may not be true, though, if much of a decedent’s wealth is tied up in an illiquid closely held business. Fortunately, the federal tax code includes a provision that allows estates of small business owners to defer the taxes and pay them in installments over time, if certain requirements are satisfied.

Eligible Estates

Section 6166 of the Internal Revenue Code provides an extension of time to pay estate taxes attributable to an interest in a closely held business in annual installments. The IRS defines an interest in a closely held business as:

• A proprietorship that carries on a trade or business,
• A partnership that carries on a trade or business, where 1) the decedent partner’s interest was at least 20% of the total capital interest in the partnership, or 2) the partnership has no more than 10 partners, or
• Stock in a corporation that carries on a trade or business, where 1) the gross estate includes at least 20% of the value of the voting stock, or 2) the corporation has no more than 10 shareholders.

The value of the business interest for purposes of the deferral excludes the portion attributable to passive assets held by the business.

To qualify for installment payments, three criteria must be met:

1. The decedent was a citizen or resident of the United States on the date of death,
2. The value of the interest in the closely held business was more than 35% of the adjusted gross estate, and
3. The election request is included with a timely filed Form 706, “Federal Estate Tax Return,” or an amended return within six months of the non-extended due date for the return. (Late filing invalidates the election.)

The adjusted gross estate is the gross estate less certain deductions. These generally include funeral and administrative expenses, claims against the estate, unpaid mortgages, and losses from casualties or theft not covered by insurance.

Special rules can make it easier to satisfy the 35% and 20% thresholds. For example, stock and partnership interests held jointly by a husband and wife are treated as owned by the decedent spouse. This treatment also applies to stock and partnership interests jointly held by the decedent and certain family members. And, if an estate holds an interest in multiple closely held businesses and has at least 20% of the total value of each, the interests may be combined and counted as an interest in a single closely held business for purposes of the 35% threshold.

Deferral Period

The maximum amount of time for the period of deferred tax payments generally is 10 years, although the executor can select a shorter period. Moreover, executors can make interest-only payments for four years, with the first tax payment (along with interest) not due until the fifth anniversary of the due date of the estate tax return. In other words, the provision gives executors a 14-year period to pay the estate taxes due on the closely held business interest.

While some might initially balk at the idea of paying interest, the rate is low. For the estate of an individual dying in 2024, it’s 2% of the first $740,000 and 45% of the prevailing rate on unpaid taxes on the balance. It’s often worth the cost to avoid draining capital or selling business assets to pay estate taxes.

Note: The IRS may require an estate permitted to pay by installment to provide a lien or bond.

Navigating the Rules

Sec. 6166 is complicated, and missteps could lead to the acceleration of tax payments.

We can help you navigate the rules and regulations to achieve the optimal result for your circumstances.