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Gifts of closely held business stock may sacrifice future savings.

Successful estate tax planning involves many alternatives. Adoption of an overall estate tax plan takes many of these alternatives into account. The use of one or more planning techniques depends on a taxpayer's personal, philosophical and financial goals.

When an owner of a closely held business dies, Sec. 6166 allows the estate to defer payment of the portion of the estate tax attributable to the business interest over 15 years. Interest will accrue on the unpaid portion of the tax, but under Sec. 6601 (j), the rate is only 4% on the first $1 million in value of the closely held business interest included in the gross estate.

Additional relief proposed: President Clinton's recent budget (proposed to Congress on Feb. 6, 1997) includes a provision that would increase the value of business interests eligible for the reduced rate of interest to $2.5 million. It would also reduce the interest rate to 2%, although the interest payments would no longer be deductible by the estate.

Caution: To qualify under current law (and under the President's proposal), the business interest must exceed 35% of the decedent's adjusted gross estate (net of funeral and administration expenses, claims and outstanding debts). If, as a result of lifetime gifts, the value of the closely held business does not meet this threshold, the executor cannot take advantage of this provision.

Example: B has assets valued at $7,000,000, which include his 25% interest in B Inc. (worth $2,500,000). If B died without making any gifts, B's estate would be entitled to make the Sec. 6166 election (see below). If, on the other hand, B gives $300,000 of B Inc. stock to his children before his death, the retained value of B Inc. in his estate would no longer exceed 35% of his total estate.
 No gift After $300.000 gift

Value of business $2,500,000 35.7% $2,500,000 37.3%
Other assets 4,500,000 64.3% 4,200,000 62.7%

Total estate value $7,000,000 100.0% $6,700,000 100.0%


Result: By making gifts of the closely held stock, B has forfeited the opportunity for his estate to make the Sec. 6166 election.

Even if the value of B Inc. exceeded the 35% threshold after these gifts, the portion of B's estate entitled to the preferential interest rate on the deferred tax will be reduced below the upper limit of $2.5 million under the President's proposal.

Suggestion: To take full advantage of the proposal, B should not have diminished his business holdings below 35% and not below $2.5 million. Instead, he could have given his nonbusiness property to his children, thereby preserving the opportunity for tax deferral.
 No gift After $300,000 gift

Value of business $2,500,000 35.7% $2,200,000 32.8%
Other assets 4,500,000 64.3% 4,500,000 67.2%

Total estate value $7,000,000 100.0% $6,700,000 100.0%


Result: By altering the subject of Bs gifts. B's estate has maximized the portion of the estate tax that can be deterred at preferential interest rates.

Looks can be deceiving: The President's proposed increase to $2.5 million is not simply a 150% increase. The mechanics of Sec. 6601(j) operate in a manner that further increases the benefit. Under current Sec. 6601 (j), the portion of the deferred tax subject to the 4% rate is the lesser of (1) $345,800 less the amount of the unified credit allowable under Sec. 2010 or (2) the amount of the estate tax attributable to the closely held business. Note: $345,800 is the tentative tax on $1 million at the lowest estate tax rates. But the tentative tax on $2.5 million is $1,025,800. If the limit is increased as under the President's proposal, the estate will be entitled to defer an additional $680,000 ($1,025,800 - $345,800) of tax subject to preferential interest rates. The reduction from 4% to 2% may be largely illusory, because the tax will no longer be deductible (see the calculation).

Example continued: IF B's taxable estate is $6,700,000, the estate tax will be $3,133,000. The following chart shows the portion of the state tax entitled to preferential interest and the interest incurred both the present and the proposed laws.
 Current Budget Increase/
 law proposal (decrease)

Estate tax available
preferential rates $153,000 $833,000 $680,000

Yearly interest on deferral:

Current law
$153,000 @ 4% - deductible
(@ 55% tax = 1.8% net) 2,754 N/A
$680,000 @ 9% - deductible
(@ 55% tax = 4.05% net) 27,540 N/A

Budget Proposal
$153,000 @ 2% (nondeductible) N/A 3,060
$680,000 @ 2% (nondeductible) N/A 13,600

Total 30,294 16,660 (13,634)

Interest accumulated over 5 years:

Current law
$153,000 @ 4% - deductible
(@ 55% tax = 1.8% net) 14,275 N/A
$680,000 @ 9% - deductible
(@ 55% tax = 4.05% net) 149,315 N/A

Budget proposal
$153,000 @ 2% (nondeductible) N/A 15,924
$680,000 @ 2% (nondeductible) N/A 70,775

Total $163,590 $86,699 $76,891


Result: By preserving the ability to take advantage of the Sec. 6601 (j) proposals, B can enhance the value of an already potent estate reduction tool.
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Article Details
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Author:Liguori, Albert W.
Publication:The Tax Adviser
Date:May 1, 1997
Words:890
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