Why IRC Section 6166 Is Outmoded
By Joseph E. Godfrey III, CLU, and Steven M. Schanker, Esq.
Prudent estate planning would indicate that federal estate tax will be due for private business owners that die before 2010 or after 2011; should death occur in 2010, there would be a capital gains tax at death when carry-over basis reemerges. This means that for businesses, there will always be a demand for cash beyond that which the typical private company carries.
IRC Section 303 Revisited
IRC section 303 presents a number of benefits for business owners. Briefly summarized, cash comes out of the business without income or capital gains taxes to pay—
In other words, estates could effectively take tax-free money from the business to pay transfer taxes and expenses. Even with all these benefits, however, business owners might be reluctant to commit to buying life insurance.
IRC Section 6166: Then and Now
IRC section 6166 allows the installment payment of the estate taxes if the value of the business exceeds 35% of the gross estate. Because the government would loan the taxpayer money at only 2.0% interest on the first $474,000 of tax due, with interest-only payments for the first five years, and interest equal to only 45% of market rates on the rest, with a payout over the next 10 years, this is a very attractive option.
Unfortunately, this strategy is no longer available. The General Accounting Office (GAO) audited the taxpayers that elected for IRC section 6166 and discovered massive noncompliance. Not only were taxpayers not repaying the principal, they weren’t even paying the 2.0% interest. By one estimate, the government lost billions of dollars in taxes and interest due.
What can the government do about it? The IRS can require the estate to obtain a surety bond for up to double the amount of the tax that is being deferred. The provision has always been in the IRC; the IRS just never paid attention. Now, it is being forced to.
This means that the installment payment of estate taxes is no longer a feasible
strategy because the new requirements are too onerous. Business owners may not
be able to afford the surety bond or it may not be available at any price. Even
IRS officials acknowledge that a surety bond could be difficult or impossible
The alternative, pledging assets with a UCC lien, is also untenable because the only assets likely to be available will be the business itself. Once a business has an
RS lien on it, the owners will find borrowing money to be nearly impossible, plus the government would now be looking over their heirs’ and executors’ shoulders as they run the businesses. The heirs will probably want to walk away with the rest of the estate’s assets, so they will not want the lien to appear elsewhere. Either way, the government will get its money, and the heirs might end up with little or nothing.
Building the “Cash Cushion” to Finance Section 303
The end of the IRC section 6166 arrangement casts IRC section 303 in a new light. The challenge is finding the cash at death. Setting aside the obvious—life insurance—there are other alternatives:
Life insurance obviates all of the problems above. The event that creates the need for cash—death—creates the cash. How the premiums are paid and from which sources (e.g., the business, FLP, LLC, a profit-sharing plan) is also important. Who receives the cash proceeds (e.g., FLP, LLC, an irrevocable life insurance trust) is a function of the creativity and professional assistance of the life insurance professional working in concert with other financial advisors.
This strategy cannot be “if” insurance: “If the business owner dies before a certain event or certain date.” This must be purchased and structured as “when” insurance—“When the business owner dies it will pay”—thereby providing the requisite liquidity. It must be permanent life insurance, not term insurance, which may expire before the business owner dies. This is crucial, because death is the ultimate exit event, and the mortality table is still 100%. Credit is queen, cash is king, and the government will get its cash.
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