Yes, estate taxes can be paid in installments, offering a crucial mechanism for estates that hold significant value in illiquid assets, such as a closely held business. This option helps prevent the forced sale of a family business or other key assets to meet immediate tax obligations, thereby preserving the estate's primary value.
Understanding Estate Tax Installment Payments
The ability to pay estate taxes over time is typically available under specific provisions of tax law, most notably Section 6166 of the Internal Revenue Code. This provision allows for a deferral and installment payment of federal estate tax attributable to a closely held business interest. It's designed to provide relief to estates where the primary asset is a business that would otherwise need to be liquidated to pay the estate tax, potentially disrupting its operations or existence.
Eligibility Criteria for Installments
To qualify for estate tax installment payments, certain conditions must be met:
- Closely Held Business Interest: The value of the closely held business interest included in the gross estate must exceed 35% of the adjusted gross estate. This ensures that the illiquidity stems from a substantial business asset.
- Business Definition: The interest must be in an active trade or business. Passive assets, like investment properties, generally do not qualify.
- Estate Composition: The estate must be unable to pay the tax without undue hardship.
Examples of qualifying business interests include:
- An interest as a proprietor in a trade or business.
- An interest in a partnership carrying on a trade or business if 20% or more of the capital interest in the partnership is included in the gross estate, or the partnership has 15 or fewer partners.
- Stock in a corporation carrying on a trade or business if 20% or more in value of the voting stock is included in the gross estate, or the corporation has 15 or fewer shareholders.
The Installment Payment Schedule
The payment schedule for estate taxes under these provisions is structured to provide significant deferral and flexibility.
The payment timeline typically unfolds as follows:
- Initial Deferral Period (Years 1-4): For the first four years following the original due date of the estate tax, the estate is generally only required to pay interest on the deferred tax amount. The principal amount of the estate tax is deferred during this period.
- Principal & Interest Payments (Years 5-14): Beginning on the fifth anniversary of the original estate tax due date, the estate begins to make annual installment payments of the estate tax itself, plus interest. These payments can be spread out over up to 10 years, meaning the total payment period, including the initial deferral, can extend up to 14 years.
| Payment Period | Obligation | Duration |
|---|---|---|
| Years 1-4 | Interest Only | 4 Years |
| Years 5-14 | Principal + Interest | Up to 10 Years |
This extended payment plan allows the business to generate sufficient income or for other arrangements to be made to cover the tax liability without forcing an immediate sale of the business.
Benefits and Considerations
Utilizing estate tax installment payments offers distinct advantages but also comes with important considerations:
Benefits
- Preserves Business Continuity: Prevents the forced sale or liquidation of a family business, allowing it to continue operations and potentially grow.
- Liquidity Management: Provides essential liquidity relief to the estate, especially when a significant portion of its value is tied up in illiquid assets.
- Financial Flexibility: Allows the estate and heirs more time to plan and manage finances, potentially finding alternative funding sources or structuring a more orderly transition of the business.
Considerations
- Ongoing Interest: While the principal is deferred, interest accrues on the unpaid tax liability. The interest rate can be preferential for a portion of the tax but can still accumulate to a substantial sum over 14 years.
- Complexity: Electing and managing installment payments involves complex tax rules and ongoing compliance requirements, often necessitating professional advice.
- Accelerated Payment Risk: If certain events occur (e.g., disposition of a significant portion of the business interest), the unpaid tax and accrued interest can become immediately due.
How to Elect Installment Payments
To elect installment payments for estate tax, the executor of the estate must generally make a timely election by filing Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, along with a statement explaining how the estate qualifies for and is electing the installment payments. This election must be made by the due date of the estate tax return, including extensions.
