The tax code has little patience for owners without estate plans.
Excuses, excuses. Convincing owners of businesses that an estate plan is a necessary evil can be more difficult than devising the plan itself. Those who avoid drawing up an estate plan may ultimately force the family to sell the business and possibly even personal assets in order to pay the estate tax within nine months of the owner's death, as required by law.
One excuse is the unlimited marital deduction — which allows you to leave your entire estate to your spouse tax free. After the spouse dies, they reason the kids will handle estate taxes from the business's cash flow. But this approach may strain the family business, just when it is losing its creative force.
Some otherwise astute owners of small businesses seem not to be worried because the IRS lets their heirs pay off the tax bill at 4 percent. The owners don't plan to die intestate, of course; they havea will that divvies up their assets to their survivors, who, the executives think, can take up to 15 years to pay estate taxes at the 4 percent rate.
In making these assumptions, the owners are relying on a somewhat obscure section of the tax code, IRC 6166, which outlines the terms under which heirs can pay off estate taxes. But the benefits of 6166 are elusive. It comes with all sorts of restrictions and qualifications that can ultimately cost more than other methods of paying estate taxes. Here are just some of the pitfalls of 6166:
- IRC 6166 allows a deferral of only a portion of the estate tax. Only the first $153,000 of taxes can be amortized at 4 percent. Any remaining estate taxes from assets must be paid out at the IRS "lending rate," currently 11 percent.
- Taxes on personal assets cannot be deferred at all. Any personal investments, including real estate (business real estate could go either way), are due in full nine months after the business owner's death.
- If the beneficiaries miss a payment to the IRS, they have a six-month grace period. But there's a price: The estate loses the 4 percent rate, and must repay the outstanding loan at 11 percent. The IRS also slaps on a service charge of 5 percent of the yearly payment per month, which raises the effective interest rate. If you don't meet payments after six months, the IRS will force you to come up with the entire balance.
Others, mostly owners of smaller businesses, hang their hopes on the so-called unified credit, which erases the first $192,800 of the estate tax bill — on the first $600,000 of assets. But a decent home and a small business puts most people above the limit.
Tax cuts of recent years have confused some small business owners into believing that the top tax rate is 28 percent. That's true for income, not estate, taxes, which can be as high as 55 percent. And don't forget the special excise tax on qualified pension money or the generation skipping tax, which together can be higher than the value of the estate!
It is unpleasant to deal with one's mortality, or worse, one's lawyers. So it is very easy to procrastinate. But the sad truth is, there is no substitute for a well thought-out plan to pay estate taxes.
Thomas F. Commito, an attorney, is vice-president, marketing operations, at National Life Insurance Co., in Montpelier, Vermont.