In a recently issued IRS Internal Legal Memorandum (ILM), the IRS indicated interest paid on estate taxes accrued during the extension period for paying tax, under code §6166, is personal interest under §163(h)(2) and thus nondeductible. Although this Chief Counsel Advise may not be cited or used as precedent, it does reflect the current thinking of the IRS.
An estate owing income and estate taxes, but lacking liquid assets to pay the taxes, requested and was granted (due to the economic hardship) a §6166 extension, which allows additional time for paying the estate tax. Interest on the unpaid estate tax accrues during the period of extension for paying the tax.
The estate claimed a deduction on the income tax return for the interest due on the unpaid estate tax. Later, the estate tax and interest due under §6166 extension was paid through the sale of real estate. The issue the IRS ruled on was whether interest on the estate tax accrued during the extension period is deductible under §163.
The IRS concluded the interest on the estate tax accrued during the extension period constitutes nondeductible, personal interest under §163(h)(2).
Generally, all federal estate taxes must be paid in full within nine months of the estate owner’s death. However, several sections in the Internal Revenue Code provide relief under certain circumstances which allow an executor to pay the federal estate taxes over a period of years.
1) Code §6166, at the IRS’s discretion, may extend the period for payment of tax for up to 10 years beyond the due date of the estate tax return. This will only be allowed if the IRS finds there is “reasonable cause” for granting such an extension.
2) Code §6163 allows for the deferral of the estate tax attributable to reversionary and remainder interests in property until after preceding interests in the property terminate.
3) Code §6166 allows a four-year deferral of tax followed by a maximum 10-year payout of the tax if the estate meets certain tests.
In general, code §163(a) provides an income tax deduction for interest paid or accrued within the taxable year on indebtedness. However, the exception to this rule is that there is no allowance for deduction on personal interest. Under code sub-section 163(h)(1), no deduction is allowed for personal interest paid or accrued during the taxable year. There are only six types of interest listed in §163(h)(2)(A) – (F) that qualify as deductible, non-personal interest.
§163(h)(2)(E) states that where an extension of time for payment of estate tax is in effect under code §6163, the interest payable on the estate tax during that period of extension is allowable as an income tax deduction. However, when §163(h)(2)(E) was amended, Congress added §163(k) which explicitly states that interest payable on estate tax during the period of extension under §6166 is not deductible under §6163. This applies even though the temporary Income Tax Regulations have not yet deleted referenced to §6166 and §6166A. So other than interest payable on estate tax during a period of extension under §6163, all interest with respect to extensions of time for paying estate tax are considered personal interest for purposes of the income tax deduction, and thus nondeductible. If the interest was related to trade or business, investment and passive activities, it could qualify as non-personal interest under §163(h)(2)(A).
Many advisors suggest the use of §6161 or §6166 as an alternative to funding the estate taxes with life insurance. However, this is likely the most expensive solution. More importantly, neither §6161 or §6166 can be considered a “sure thing”, and thus is less than 100% reliable as a pre-mortem tax deferral planning device.
Some issues to consider regarding the use of §6161 and §6166 are as follows:
1) Estates seeking the installment tax payment relief permitted by §6166 can be required by the IRS to purchase a bond or special lien. Even though the IRS cannot require this in every case, the uncertainty of this requirement remains. In addition, there is a mathematical percentage test of more than 35% of A.G.E., which may not be met in order to qualify for §6166. Also, the descedant’s business may not meet the test for a qualified company. Lastly, the executor may not be able to post the required bond or may determine the cost of such bond is prohibitive. Likewise, a lien may be impractical or unacceptable to the heirs.
2) Neither §6161 nor §6166 create the cash to pay the tax. The right to make installment payments does nothing more than postpone the necessity of paying a certain portion of the total estate tax. Nondeductible interest added to the tax due will only increase the total cost substantially to the estate. Advisors must determine where the estate will find the money to pay both the tax and the non-deductible interest. If it must come from the descedant’s business, then it will most likely come in the form of a dividend and therefore be after tax dollars.
3) The right to make installment payments of the estate tax may only cover a portion of those federal taxes due. The estate must still find the cash to pay the administrative expenses, debts and state death taxes (if the client has assets in a decoupled state), income tax and pecuniary bequests.
4) Lastly, the executor may remain personally liable for the unpaid taxes during the entire deferral period, which could last as long as 14 years in the case of a §6166 election. Not only will the executor remain liable, but the final distribution to the beneficiaries will also be delayed. Due to these facts, few personal representatives will be comfortable with the extended liability, and even fewer heirs may want to wait that long to collect their inheritance. In addition, the guardians of minor beneficiaries must sign the elective agreement to discharge the executor from personal liability, and thus would be rightfully hesitant to sign such an exoneration.
In the end, a §6166 election may make sense as part of an overall estate plan, especially if it is coupled with the use of life insurance and/or a properly funded §303 redemption if utilizing a business. However, as a tool by itself, in spite of or perhaps because of recent developments such as the recently issued Internal Legal Memorandum which emphasizes that interest is non-deductible, it now seems to be more problematic.