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Improved estate tax deferral rules for real estate

In a new revenue ruling, the IRS has provided some concrete and helpful examples of real property interests which do, and do not, constitute active interests in a closely-held business eligible for estate tax deferral under Internal Revenue Code section 6166. Auto dealerships and other businesses which operate on personally owned realty get specific help.

Section 6166 allows an executor to pay the estate tax attributable to a closely-held business interest over 15 years, with interest only due during the first five years. Further, the IRS interest rate on the first $1 million of deferral tax is 2%, a real bargain. Even for larger amounts, the interest rate is 45% of the normal IRS rate, but is not deductible. In order to take advantage of this deferred payment, the value of the closely-held business interest must constitute at least 35% of the decedent’s adjusted gross estate, and either the decedent must own at least 20% of the business or there must be 45 or fewer owners. The last important requirement is that the business must be active, which is a hard test to apply to real estate ventures. This IRS ruling, through specific examples, fleshes out the active business requirement for real estate ventures further than ever.

Facts of Example 1

When Alice died on January 1, 2005, she owned a ten-store strip mall titled in her name. She personally handled its day-to-day operation, management and maintenance. She hired third party independent contractors to do repairs that she couldn’t personally do herself. Alice approved and reviewed the work done by the independent contractors.

Ruling

Alice’s ownership of the strip mall qualifies as an interest in a closely-held business, because she provided significant services.

Facts of Example 2

When Barbara died on February 1, 2005, she owned a small office park titled in her name. It had five separate two-story buildings, each with multiple tenants. Barbara hired DEF Management Corporation (DEF), a property management company in which she had no ownership interest, to lease, manage and maintain the office park, and she relied entirely on DEF to provide all necessary services. DEF provided a monthly accounting statement to Barbara and also provided her with a check for rental income minus expenses and fees.

Ruling

Barbara was not a proprietor in an active trade or business, and her interest does not qualify as an interest in a closely-held business. DEF provided all the management services, and Barbara lacked any ownership interest in DEF.

Facts of Example 3

Same as Example 2, except Barbara owned 20% of the stock in DEF.

Ruling

Since Barbara owned a significant interest in DEF, the interest in the office park qualifies as an interest in a closely-held business. The management company’s activities were attributed to Barbara as an owner.

Facts of Example 4

When Charles died on April 1, 2005, he owned the 1% general partner interest and a 20% limited partnership interest in a limited partnership that owned three strip malls. The partnership agreement required Charles, as the general partner, to provide the limited partnership with all services necessary to operate the limited partnership’s business, including maintenance and service of the strip malls. From 1992 until his death, Charles received an annual salary for his services as the general partner. In performance of his obligations under the limited partnership agreement, he performed or delegated substantial management functions (rent collection, repairs and negotiating leases) and made decisions regarding renovations of the three strip malls.

Ruling

Charles’ interest in the limited partnership qualifies as an interest in a closely-held business limited partnership. In his role as general partner, Charles handled all operations and management of the strip malls.

Facts of Example 5

When Dale died on May 1, 2005, he owned 100% of the stock in MNO Corporation (MNO), an auto dealership. Dale supervised all employees and made all corporate decisions. In addition to the stock of MNO, Dale directly owned Real Property T, which was constructed for MNO and contained unique features for the auto dealership. Dale leased Real Property T to MNO under a net lease, and MNO’s employees performed all maintenance of and repairs to Real Property T.

Ruling

Dale’s 100% MNO stock interest at the time of his death qualifies as an interest in a closely-held business. Because Dale owned a significant interest in MNO, whose activities with regards to Real Property T constituted active management, Dale’s interest in Real Property T also qualifies as an interest in a closely held business.

Conclusion

This ruling liberalizes the scope of section 6166 as it applies to real estate in a number of ways. If you have significant real estate holdings, it could prove helpful to you in obtaining a long-term estate tax deferral for the holdings.

  • Partner

    John is a partner in the firm's Estate Planning Department. He focuses his practice on estates, trusts, family business and disability planning, and the administration of estates and trusts. John also has an active health law ...

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