Estate Liquidity

Estate liquidity is the ability of a deceased person's estate to produce cash when the estate's obligations fall due: federal estate tax where any is owed, state death taxes, the decedent's debts, funeral costs and the expenses of administration. An estate can be large and illiquid at once, and that combination is the whole subject. A farm, an operating business, a rental property or a house is worth what it is worth, and none of them turns into money in nine months without somebody selling something.

The phrase is a description rather than a legal term. It appears in no statute or Treasury regulation, and it names a condition of an estate rather than an instrument or an election. What gives it substance is that the tax code contains four specific answers for an estate that owes money it cannot readily raise, and the useful thing to know about estate liquidity is what those answers are and which ones an estate qualifies for.

Start with the deadline, because everything else is a response to it. Section 6075(a) requires the federal estate tax return within nine months of the date of death, and section 6151(a) makes the tax payable when the return is due. A six-month extension of time to file is available on request, and it is not an extension of time to pay. So the default position is that cash has to exist nine months after a death, in an amount nobody planned for on a date nobody chose.

Answer one: pay in installments, if the estate is mostly a closely held business. Section 6166 is headed "Extension of time for payment of estate tax where estate consists largely of interest in closely held business," and it does two things at once. If the value of an interest in a closely held business included in the gross estate "exceeds 35 percent of the adjusted gross estate," the executor may elect to pay part of the tax "in 2 or more (but not exceeding 10) equal installments," and under (a)(3) the first of those may be deferred for up to 5 years after the normal due date.

Three details decide whether it is available. "Adjusted gross estate" is defined at 6166(b)(6) as the gross estate reduced by deductions allowable under sections 2053 and 2054. An "interest in a closely held business" at 6166(b)(1) means a proprietorship, a partnership interest where 20 percent or more of the total capital interest is in the gross estate or the partnership had 45 or fewer partners, or corporate stock where 20 percent or more in value of the voting stock is in the gross estate or the corporation had 45 or fewer shareholders. And 6166(a)(2) caps what may actually be deferred: the same ratio of business value to adjusted gross estate, applied to the tax. Passing the 35 percent test does not defer the whole bill; it defers a proportion of it.

The election is made on a timely filed return under 6166(d), and it can be lost. Under 6166(g)(1)(A), if dispositions of the business interest and withdrawals of money from it together reach 50 percent of its value, the extension "shall cease to apply" and the unpaid balance falls due on notice and demand. Two carve-outs matter to a family: a redemption under section 303 is not counted as a disposition or withdrawal for that test, on conditions set out at (g)(1)(B), and neither is a transfer of the property at death to someone entitled to receive it under the will, intestacy or the decedent's trust, nor a series of later transfers at death within the family.

Answer two: ask for more time on reasonable cause. Section 6161 is separate machinery and it does not require a business at all. Section 6161(a)(2) lets the IRS extend payment of estate tax "for reasonable cause" for a period "not in excess of 10 years" from the date prescribed by section 6151(a). Section 6161(b)(2) allows up to 4 years for a deficiency, again for reasonable cause, and 6161(b)(3) shuts the door where the deficiency is due to negligence, intentional disregard of the rules, or fraud. Section 6165 permits the IRS to require security for an extension granted under either route. This is discretionary relief rather than an election, which makes it less certain than section 6166 and much wider in what it can reach.

Answer three: let the corporation buy the stock back. Ordinarily a closely held corporation redeeming a shareholder's stock risks having the payment treated as a dividend, taxable in full rather than against basis. Section 303 removes that risk for a specific purpose. A redemption of stock included in the gross estate "shall be treated as a distribution in full payment in exchange for the stock so redeemed," to the extent the distribution does not exceed the sum of the death taxes imposed because of the death, including interest collected as part of them, and the funeral and administration expenses deductible under section 2053.

Section 303's own threshold at (b)(2)(A) is worth comparing with section 6166's. It requires that the value of all the corporation's stock included in the gross estate exceed 35 percent of the gross estate minus deductions under sections 2053 and 2054, which is the same quantity section 6166 calls the adjusted gross estate. The two tests therefore share a denominator and measure different numerators, so an estate can qualify for one and not the other. Where 20 percent or more in value of the outstanding stock of each of two corporations is included in the gross estate, (b)(2)(B) treats them as a single corporation for the test. Subsection (b)(3) limits the relief to the extent the shareholder's interest is actually reduced by paying those taxes and expenses, and (b)(4) narrows it further for distributions made more than 4 years after the death.

Answer four: have cash arrive from outside the estate. A life insurance policy the decedent did not own is not in the gross estate, so it adds nothing to the tax while producing cash on the day it is most needed. The usual structure holds the policy in an irrevocable trust, and the trust then buys assets from the estate at fair value or lends it money, which puts cash into the estate without the estate having to sell the farm to a stranger. The ownership rules that make this work, and the argument about which kind of policy to use, belong to the insurance entries; the point here is that this is the only one of the four answers that has to be arranged before the death.

What an executor actually works through, and then the arithmetic on the installment test.

1. Size the obligation. Federal estate tax where any is owed, state death taxes, debts, funeral costs and administration expenses, against a due date nine months after the death.

2. Inventory what can be turned into cash by that date, and at what discount. A minority interest in a family business usually cannot be sold at all in that window.

3. Test the 35 percent thresholds. Section 6166 measures a closely held business interest against the adjusted gross estate; section 303 measures all of one corporation's stock against the same denominator.

4. Make the elections on the return. Section 6166 requires the election on a timely filed return; a section 6161 extension is a request for discretionary relief.

5. Protect the deferral afterwards. Watch the 50 percent disposition-and-withdrawal test for as long as installments run, and use the section 303 carve-out rather than an unplanned distribution.

A hypothetical, with the ratio worked out. Marisol dies owning a farming operation together with other property. Her gross estate is $28,000,000, of which the closely held business interest is $13,500,000. Deductions allowable under sections 2053 and 2054, meaning debts, funeral and administration expenses and losses, come to $1,000,000, so the adjusted gross estate is $27,000,000.

The threshold test: 35 percent of $27,000,000 is $9,450,000. The business interest of $13,500,000 exceeds that, so section 6166 is available.

The cap on what may be deferred: the business is $13,500,000 of a $27,000,000 adjusted gross estate, a ratio of 50 percent. Assume for the illustration that the federal estate tax finally due after all credits is $4,000,000; the real figure depends on the exclusion in force and on lifetime gifting, and it is not the point here. Half of that, $2,000,000, may be paid in installments. The other $2,000,000 is due nine months after the death, like any other estate tax.

Spread over the maximum 10 installments, the deferred half is $200,000 a year, with the first payment able to fall as late as 5 years after the normal due date. Interest is charged on the deferred tax throughout.

Now add section 303. If the business is a corporation, all of whose stock in the gross estate is that same $13,500,000, it clears the section 303 threshold as well, because $13,500,000 exceeds 35 percent of $27,000,000. With death taxes of $4,000,000 and section 2053 funeral and administration expenses of $400,000, the corporation may redeem up to $4,400,000 of its own stock from the estate with exchange treatment rather than dividend treatment. And because section 6166(g)(1)(B) carves a section 303 redemption out of the 50 percent acceleration test, doing so does not, by itself, collapse the installment plan. That carve-out is conditional: an amount of estate tax at least equal to the money and property distributed in the redemption has to be paid by the date (g)(1)(B) sets.

Pros of planning for it in advance

• Section 6166 can turn a single nine-month deadline into as long as 14 years of scheduled payments for an estate built around a family business.
• Section 6161's reasonable-cause extension is not limited to business estates, so it reaches an estate whose problem is a house, land or an unsellable interest.
• Section 303 lets a corporation supply cash to the estate without the distribution being taxed as a dividend, and section 6166(g)(1)(B) keeps such a redemption out of the acceleration test if its payment condition is met.
• Life insurance held outside the estate produces cash on the exact day it is needed, in an amount that can be sized to the expected bill, and adds nothing to the taxable estate.
• Every one of these is easier to arrange while the owner is alive, which is the practical argument for looking at it early.

Cons and limits

• Section 6166 defers only the proportion of the tax that the business bears to the adjusted gross estate, not the whole bill, and interest runs on what is deferred.
• The 50 percent disposition-and-withdrawal test can accelerate the entire remaining balance years later, so the heirs inherit a constraint on what they may sell.
• Section 6161 relief is discretionary rather than elective, requires reasonable cause, is unavailable for a deficiency caused by negligence or fraud, and can be conditioned on posting security.
• Section 303 works only where one corporation's stock is more than 35 percent of the same denominator, and it is capped at the taxes plus funeral and administration expenses rather than at whatever the family needs.
• Insurance is the only answer that must be in place before the death, and it has to be owned so that it is not in the estate, which takes deliberate structuring rather than simply buying a policy.