How to Defer Estate Tax on Business Interests

If you’re a small business owner, you may have spent years—possibly even decades—building up a successful enterprise. Now you hope to enjoy the fruits of your labor as retirement looms. But you may want to secure some estate protection for your highly-valued business interest.

Currently, the generous estate tax exemption can shelter from tax bequests of up to $10 million (indexed to $12.06 million in 2022), but this figure is scheduled to revert to $5 million (plus indexing) in 2026. So your family may still face some estate tax exposure in the future.

Practical solution: Set things up 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 stretched out over ten years. As a result, your family can take up to 15 years to pay the tax. (Due to the required timing of installments, the actual deferral period is 14 years.)

Sounds good, right? But there’s a catch. Interest must be paid each year on the unpaid portion of the tax. Fortunately, however, the estate pays only 2% on the tax attributable to the first $1 million of the business interest. The interest rate for tax underpayments applies to any amount above $1 million (subject to inflation indexing). 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 requirements must be met.

1. The decedent must have been a U.S. citizen or resident at death.

2. The interest in the closely held business must comprise more than 35% of the decedent’s adjusted gross estate.

3. The election must be made by the estate’s personal representative on an estate tax return filed in a timely manner.

For purposes of the 35% test, the calculation is based on subtracting from the gross estate certain deductions such as debts, funeral expenses, administration costs, mortgages and liens. However, these deductions are taken into account prior to applying any available charitable and marital estate tax deductions.

Furthermore, you must have operated the business as one of the following:

A sole proprietor;
A partner with an interest of 20% or more in the partnership, or with an interest in a partnership that has no more than 45 partners; or
A corporate stockholder owning 20% or more of the voting stock, or owning stock in a corporation with no more than 45 shareholders.

In conclusion: That’s a lot to consider, but the effort is well worthwhile when you consider the top estate tax rate is 40%. If you qualify, meet with your estate and tax planning to make the necessary arrangements for obtaining Section 6166 relief. Your family will approve!