On the surface, it's the kind of financing a small-business owner would die for. Borrow up to 55% of the value of your company. Pay only the interest -- 2% -- for five years. Then take nine more years to pay off the balance at a variable rate that's at 2.25% today. Better yet, the lender doesn't require any security for the note.
Trouble is, to get these terms, a business owner has to die. This generous financing is the Internal Revenue Service's way of helping entrepreneurs' heirs pay off estate taxes without forcing the family business into a fire sale. But now, the IRS is putting the squeeze on these installment payments, known as Section 6166 plans for the tax-code provision that authorizes them. Permanent repeal of the estate tax -- the levy is scheduled to vanish in 2010 but reappear the following year -- is looking unlikely. So the IRS crackdown is causing problems for estate planners and heirs looking for relief in paying the still-hefty burden on estates worth $1 million or more.
The IRS has belatedly realized that some heirs were taking the idea that IRS financing could be a steal all too literally. It signed off on hundreds of installment plans without requiring security on what were effectively 14-year loans. Given the IRS's lax record of follow-up, it's no surprise that many heirs didn't maintain payments. In a March, 2000, report, the Treasury Dept. Inspector General for Tax Administration found that the IRS had no security to back up 93% of the $1.4 billion in outstanding installment plans -- and that $227 million in taxes was in arrears or written off from 439 estates that had defaulted. "Not only were the heirs skipping the tax, they weren't even paying the 2% interest," says Joseph Godfrey III, an insurance planner for the New York advisory firm, American Business & Professional Program.
So now, the IRS is acting more like a bank. While heirs can still get generous rate and payment terms, they must be prepared to put up some hefty security. One option -- post a surety bond for twice the taxes owed -- is prohibitively expensive. So planners are focusing on the second choice: an IRS lien on heirs' assets, most likely the business itself, for the tax due plus four years' interest. Opinions are split on whether that ruins what was once a cheap and easy loan.
Some planners say the installment plan money is so cheap that a lien is an acceptable burden. "Giving the IRS a formal mortgage on your business could complicate your other financings, but it's something you can work around," says Kenneth Brier, an attorney in the estate planning department at law firm Bingham McCutchen in Boston. In some cases, "there's no other way to pay the taxes without a fire sale."
Other experts warn that Section 6166 should be used only as a last resort -- usually because an entrepreneur hasn't done proper planning. "You're accepting the Treasury Dept. as a partner in your business -- and the government is not necessarily your best partner," says Carl Kempf III, a financial planner and attorney with the Albany (N.Y.) firm of Burke, Casserly, & Gable. Besides complicating future financing, the installment plan imposes a cash-flow burden on the business.
Most advisers recommend creating a plan to pass the business on to new owners -- whether heirs or managers from outside the family -- before the owner's death. Such plans can be structured to limit the tax bite: In a family limited partnership, for example, the heirs can get their stake in the business at sharply discounted values. If the plan still leaves much of the business value in the estate, a life insurance policy -- whole life or permanent insurance, not term -- in a trust owned by the heirs can produce the cash to pay taxes without forcing a sale or borrowing.
The most basic question for any aging business owner: Who wants to own and run the company? The firstborn son may be the traditional choice but isn't always the best pick. Another child or a talented employee might be a far better successor. Or the best value, along with significant tax breaks, can come from selling to an employee stock ownership plan. "If you pick the wrong successor, it isn't going to matter how you pay the taxes -- the value of the business will be gone," warns Ron Butt, who advises business owners for American Express Financial Advisors in Louisville.
That goes double if you're tempted by the IRS's offer of 2% interest. Your heirs must agree with the installment plan: The IRS won't O.K. it if one of the business' new owners balks at the lien. And they must be committed to keeping the business running throughout the 14-year plan -- or face the tax when they sell. IRS financing for estates may be cheap, but it's no longer easy. By Mike McNamee