IRS Provides Guidance Regarding Real Estate and Active Business Requirement of Section 6166
In Rev. Rul. 2006-34, 1 the IRS has provided guidance that will make it easier for estates holding real estate directly or through a partnership or corporation to qualify to pay estate taxes in installments under Section 6166.
Facts and Analysis
Section 6166 permits an executor to elect to pay the estate tax attributable to an interest in a closely held business in equal installments (not exceeding ten installments) if the decedent was a U.S. citizen or resident, and if the value of the interest in the closely held business which is included in the decedent's gross estate exceeds 35% of the adjusted gross estate.
There are several advantages of being able to pay estate taxes in installments: (1) the estate can avoid a forced sale of assets; (2) the estate can use future income to make the installment payments of estate taxes; (3) the estate can avoid the uncertainty of whether it will be able to obtain a bank loan to pay the estate taxes; and (4) the interest rate on the deferred payments is generally 45% of the interest rate applicable to underpayments of tax. Section 6166(b)(1) defines the term “interest in a closely held business” to mean:
A. an interest as a proprietor in a trade or business carried on as a proprietorship;
B. an interest in a partnership carrying on a trade or business, if—(i) 20% or more of the total capital interest in such partnership is included in the decedent's gross estate, or (ii) such partnership has 45 or fewer partners; or
C. stock in a corporation carrying on a trade or business if—(i) 20% or more in value of the voting stock of such corporation is included in the decedent's gross estate, or (ii) such corporation has 45 or fewer shareholders.
The IRS has consistently taken the position that in order for an interest in a business to qualify as an interest in a closely held business under Section 6166, the business must conduct an active trade or business rather than merely manage investment assets. Rev. Rul. 2006-34 provides guidance regarding under what circumstances real estate activities will qualify under Section 6166 as an active trade or business, and accordingly, when real estate activities will qualify under Section 6166 as a closely held business.
The Ruling states that in determining whether the activities of a business constitute an active trade or business, the activities of agents and employees of the business are to be taken into consideration. The Ruling recognizes that with a real estate business, the day-to-day operations and activities are often performed by independent contractors, such as property management companies. According to the Ruling, the fact that some activities are conducted by independent contractors (who are neither agents nor employees of the business) will not prevent the business from qualifying as an active trade or business, provided that the activities of the independent contractors are not so extensive as to reduce the activities of the business (and its agents and employees) to the level of merely holding investment property. However, the Ruling indicates that an active trade or business does not exist if a real estate business uses an unrelated property management company to perform most of the activities associated with the real estate business.
Rev. Rul. 2006-34 states that in determining whether a real estate business is engaged in an active trade or business, the IRS will consider all the facts and circumstances, including the activities of agents and employees, the activities of management companies or other independent contractors, and the decedent's ownership interest in any management company or other independent contractor. The IRS provided the following non-exclusive list of factors that will be considered:
- The amount of time the real estate business devoted to its trade or business;
- Whether an office was maintained from which the activities of the real estate business were conducted or coordinated, and whether the real estate business maintained regular business hours for that purpose;
- The extent to which the real estate business was actively involved in finding new tenants and negotiating and executing leases;
- The extent to which the real estate business provided landscaping, grounds care, or other services beyond the mere furnishing of leased premises;
- The extent to which the real estate business made, arranged for, performed, or supervised repairs and maintenance to the property (whether or not performed by independent contractors), including without limitation painting, carpentry, and plumbing; and
- The extent to which the real estate business handled tenant repair requests and complaints.
The Ruling presents five situations illustrating the application of these rules and factors. Situation 1. The decedent owned a strip mall titled in his name. The decedent personally handled the day-to-day operation, management, and maintenance of the strip mall. The decedent also personally handled most repairs. When the decedent was unable to perform a repair personally, he hired an independent contractor. The decedent selected the contractor, and reviewed and approved the work performed.
The IRS found that the decedent provided significant services to the strip mall tenants that went beyond those of a mere investor collecting profits from a passive asset. In addition, with respect to repairs that the decedent could not personally perform, he was involved in selecting the contractors, and reviewed and approved the work performed. The IRS determined that under these circumstances, the use of independent contractors did not prevent the decedent's activities from rising to the level of the conduct of an active trade or business. Therefore, the decedent's ownership of the strip mall qualified as an active trade or business for purposes of Section 6166. The IRS noted that the result would have been the same if the strip mall had instead been held in a single-member limited liability company (“LLC”) owned by the decedent.
Situation 2. The decedent owned a small office park titled in his name. The office park consisted of five separate buildings, each of which had multiple tenants. The decedent hired a property management company, in which the decedent had no ownership interest, to lease, manage and maintain the office park. The decedent relied entirely on the management company to provide all necessary services.
The primary duties of the management company consisted of advertising to attract new tenants, showing the property to prospective tenants, negotiating and administering leases, collecting the monthly rent, and arranging for independent contractors to provide all necessary services to maintain the buildings and grounds of the office park, including snow removal, security, and janitorial services. The management company provided a monthly accounting statement to the decedent along with a check for the rental income, net of expenses and fees.
The IRS stated that in determining whether the decedent was a proprietor carrying on an active trade or business with respect to his interest in the office park, the activities of the management company must be taken into account. The IRS concluded that the decedent relied on the management company to perform all necessary services; the decedent did not significantly participate in the management or oversight of the property; and the decedent did not have an ownership interest in the management company. Based on these facts, the IRS ruled that the decedent was not a proprietor engaged in an active trade or business, and thus, the decedent's interest in the office park did not qualify under Section 6166.
Situation 3. The facts are the same as in Situation 2 except that the decedent owned 20% in value of the stock of the management company. The management company provided all necessary services with regard to the management and maintenance of the office park.
The IRS found that these activities were sufficient to conclude that the management company was actively managing the office park. The IRS ruled that because the decedent owned a significant interest in the management company, the activities of the management company with regard to the office park allowed the decedent's interest in the office park to qualify as an active trade or business under Section 6166.
Situation 4. The decedent owned a 1% general partner interest and a 20% limited partner interest in a limited partnership that owned three strip malls. The partnership agreement required the decedent, as the general partner, to provide the limited partnership with all services necessary to operate, maintain, and repair the malls. The decedent received an annual salary from the limited partnership for his services as general partner. The decedent (either personally or with the help of employees or agents) performed substantial management functions, including collecting rental payments and negotiating leases, performing daily maintenance and repairs (or hiring, reviewing, and approving the work of independent contractors for such work), and making decisions regarding periodic renovations of the three strip malls.
The IRS stated that because the partnership owned the real estate, the nature and level of the activities of the limited partnership must be evaluated to determine whether the limited partnership was carrying on an active trade or business. The IRS found that the limited partnership, acting through its general partner, handled the day-to-day operations and management of the strip malls. The IRS therefore concluded that the limited partnership carried on an active trade or business. Accordingly, the decedent's interest in the partnership qualified as an interest in a closely held business for purposes of Section 6166. Because the decedent owned at least 20% of the partnership, the IRS said that the conclusion would be the same even if the decedent's activities were instead performed by another employee, partner, or agent of the partnership.
Situation 5. The decedent owned 100% of the stock in an automobile dealership. The decedent made all decisions regarding the dealership and supervised all its employees. The decedent also owned a parcel of improved real property that contained a showroom, office space, and areas for servicing automobiles and storing inventory. The real property was leased to the dealership under a net lease, and the employees of the dealership performed all maintenance of, and repairs to, the real estate.
The IRS ruled that as in Situation 3, because the decedent owned a significant interest in the dealership, whose activities with regard to the real property constituted active management, the decedent's interest in the real property qualified under Section 6166.
Rev. Rul. 2006-34 provides significant guidance to those advisors who have clients that own real estate and would like to structure their business affairs so as to qualify under Section 6166. The Ruling makes it clear that the activities of agents and employees of the decedent will be attributed to the decedent.
In addition, activities of independent contractors will not prevent an estate for qualifying under Section 6166 unless the activities of the independent contractors are so extensive that they result in placing the decedent in a position similar to that of an investor in a passive asset. Moreover, Section 6166 is available even though exclusive management and maintenance responsibility are performed by an entity other than the decedent, his employees, agents, and independent contractors—as long as the decedent has a significant ownership interest in the entity performing such functions.
?1 2006-26 IRB 1171. The Ruling revokes Rev. Rul. 75-365, 1975-2 CB 471, in its entirety, and revokes Rev. Rul. 75-367, 1975-2 CB 472, in part.
Frank S. Baldino is an attorney at Lerch, Early & Brewer in Bethesda, Maryland who practices in the areas of estate planning and probate administration and who co-chairs the firm's Estate Planning and Probate Group. He has extensive experience in the areas of estate planning, charitable giving, estate planning for non-U.S. citizens, tax planning with respect to retirement plans and stock options, asset protection planning, business succession planning and estate and trust administration. Frank may be contacted at 301-657-0715 or email@example.com.