How estate tax installments work for closely held businesses

By Richard C. Wilson

Research notice: Primary authorities are linked in the Sources below.

Eligibility depends on the business interest's value

An eligible executor may elect 2 to 10 equal annual installments, ordinarily with the first principal payment deferred up to five years after the statutory estate tax payment date. The decedent must have been a U.S. citizen or resident at death. The qualifying business interest must exceed 35% of the adjusted gross estate, and the election must be made by the estate tax return deadline, including extensions. Passive assets, the proportional tax limit and the special holding company election can restrict eligibility, the amount deferred or the payment schedule, as explained below.

The business interest must satisfy one of these tests immediately before death:

• A proprietorship carrying on a trade or business.
• A partnership carrying on a trade or business, with at least 20% of its capital included in the gross estate or no more than 45 partners.
• A corporation carrying on a trade or business, with at least 20% in value of its voting stock included in the gross estate or no more than 45 shareholders.

Adjusted gross estate means gross estate reduced by allowable deductions under IRC §§2053 and 2054. Determine those deductions using the circumstances existing at the estate tax return filing deadline, including extensions, or the actual filing date if earlier. Marital and charitable deductions do not reduce this denominator.

The maximum tax payable in installments is the share of estate tax after credits that bears the same proportion to that tax as the qualifying closely held business amount bears to the adjusted gross estate.

Partnerships and holding companies

Passive assets do not count toward either the 35% eligibility test or the deferrable amount. Exclude the value attributable to assets not used in carrying on a trade or business. Stock in another corporation is generally passive. The active subsidiary exception applies when the 20% voting stock ownership or 45 shareholder test is met and at least 80% of each corporation's asset value is attributable to assets used in a trade or business. The passive asset exclusion does not apply to the acceleration test.

A separate holding company election lets the executor treat underlying business company stock as directly held. It applies to the portion of holding company stock representing direct ownership, or indirect ownership through other holding companies, in a corporation carrying on a trade or business. Generally, the stock must have had no stock exchange or over the counter market at death. Deemed stock counts as voting stock only to the extent voting stock through the ownership chain owns voting stock in the business company.

This holding company election eliminates initial principal deferral and sets the preferential interest portion to zero. If the general market restriction fails but all stock of each holding company considered is not readily tradable, the election permits no more than five installments.

Active business requirements for real estate operations

The IRS ruling's examples assume that the real property interests were included in the gross estate, exceeded 35% of adjusted gross estate and met the entity ownership or headcount requirements. Under those assumptions, the strip mall owner who handled daily operations and maintenance, selected contractors and reviewed their work qualified. The owner relying entirely on an unrelated manager without significant participation or ownership did not qualify. The otherwise similar owner with 20% ownership of the company actively managing the property qualified. That ownership percentage is not a universal safe harbor.

The election notice accompanies the estate tax return

Make the election by attaching a notice to a timely estate tax return. The notice must state:

• The decedent's name and taxpayer identification number.
• The elected tax amount.
• The first installment date.
• The number of annual installments, including the first.
• The qualifying properties, identified by return schedule and item.
• The facts supporting qualification.

If the notice leaves the tax amount, first payment date or installment count unstated, the regulation supplies the corresponding default. Those defaults are the maximum eligible amount, a first payment five years after the statutory payment date and ten equal installments. Special election limits still apply, including the holding company limits above.

When values remain unresolved

A protective election preserves a contingent election only if final values satisfy the installment requirements. Make it by attaching a notice to a timely estate tax return stating that the election is being made. The protective notice itself does not extend payment.

Within 60 days after values are finally determined or agreed following examination, the executor must file a final notice with the office where the original estate tax return was filed. Include the name and taxpayer identification number, elected tax amount, first installment date, installment count, property identification and qualifying facts listed above. With that notice, pay installments and interest then due, plus other unpaid tax and interest not eligible for, or covered by, another extension.

Payment timing and interest

Common questions about payment timing

The preferential portion is the lesser of the tentative estate tax calculated under IRC §2001(c) on the applicable exclusion plus an annually indexed input, minus the applicable credit, or the tax extended under the installment provision. It is not simply a fixed dollar amount of deferred tax. The special holding company election sets this portion to zero.

For estate tax extended under the installment provision, interest is 2% on the preferential portion and 45% of the otherwise applicable annual rate on the excess. This treatment includes deficiencies prorated to installments. When total deferred tax exceeds the preferential portion, payments reduce that portion proportionately. The special holding company election sets the preferential portion to zero. The late payment rule below removes this interest treatment from a late payment paid within six months.

Interest payable under IRC §6601 on unpaid federal estate tax imposed by IRC §2001 during an IRC §6166 extension is deductible under neither IRC §2053 nor IRC §163. This rule concerns interest for the period the extension is in effect.

Missing a principal or interest payment

If principal or interest is not paid by its deadline, including any extension, the unpaid installment tax balance becomes payable on notice and demand. Paying within six months avoids acceleration for that payment. However, that payment loses the IRC §6601(j) interest treatment and incurs a penalty of 5% of the payment for each month or fraction after the deadline and before payment.

Estate income during the installment period

An estate with an installment election must use statutory undistributed net income to reduce unpaid installment tax for taxable years ending on or after the first installment due date. The executor must pay it by the estate income tax return deadline, including extensions.

This income is distributable net income under IRC §643 less the distribution amounts specified in IRC §661(a)(1) and (2), estate income tax, and estate tax plus interest paid that year outside this requirement. Under the special holding company election, business company dividends paid to the holding corporation count as paid to the estate to the extent attributable to qualifying stock.

Transactions that end the right to pay in installments

Bonds and special liens

The IRS may require a bond of no more than twice the amount extended, conditioned on payment under the extension.

An executor with an installment election may elect a special federal lien covering the deferred amount and attributable interest, additions, penalties and costs. The executor must file a written agreement signed by every living person with an interest, whether or not in possession, in the designated property. Those property interests must be expected to survive the deferral period. The signers must consent to the lien and designate a responsible agent.

Resources to check out

• IRS Instructions for Form 706: Filing reference for the installment election and related disclosures.
• IRC §6166: Business interest estate tax installments: Statutory text for eligibility, elections and payment rules.
• Revenue Ruling: Real estate operations: Factors and factual examples for the rental activity review.
• IRC §6601(j): Installment interest: Interest rates and preferential portion provisions.
• Revenue Procedure: Inflation adjustments: Section 4.51 provides the applicable calculation input.