Rev. Rul. 89-4

1989-1 C.B. 298, 1989-2 I.R.B. 7.

                       Internal Revenue Service

                                 Revenue Ruling

        EXTENSION OF TIME FOR PAYMENT; ESTATE TAX; CLOSELY HELD BUSINESS

                           Published: January 9, 1989

26 CFR 20.6116A-3. Acceleration of payment

(Also Section 2032A.)

   Extension of time for payment; estate tax; closely held business. Sale of specially valued property to a person, not a qualified heir, where proceeds reduced debt on assets of the ongoing business, is not a disposition for purposes of section 6166(g)(1)(A) of the Code, but is a disposition for purposes of section 2032A.

  An individual died in 1983, leaving an estate consisting primarily of a closely held farming business. One tract of land held by the estate had a fair market value of $700,000, but was encumbered by mortgage and accrued interest of $400,000. A second tract had a fair market value of $500,000, but was encumbered by a mortgage and accrued interest of $300,000. The adjusted gross estate had a total value of $700,000, while the adjusted value of the farm land was $550,000.

  The estate elected section 2032A special use valuation for the farmland, and elected to defer the payment of a portion of the estate tax under section 6166.

  In 1988, the outstanding mortgages on the two tracts of land were in delinquent status and foreclosure was imminent. To stem foreclosure, the estate sold the first tract for $700,000 to a nonqualified heir. The estate used the entire proceeds to retire the mortgages on both tracts. The transaction left the farming business with an adjusted value of $550,000, consisting of $500,000 in unemcumbered real estate and $50,000 in equity in farming equipment and other assets.

  ISSUES. At issue is whether the sale to the nonqualified heir, undertaken to allay impending foreclosure, constitutes a disposition of an interest in the closely held farming business for purposes of section 6166(g)(1)(A). Secondly, will the sale of specially valued property be treated as a disposition requiring recapture under section 2032A(c)?

  HOLDING. The Service, citing the statute's underlying purpose, has ruled that the sale to the nonqualified heir, undertaken to allay impending foreclosure, will not be treated as a disposition of an interest in the closely held farming business for purposes of section 6166(g)(1)(A).

  Noting the unconditional terms of section 2032A(c), the Service ruled the sale of specially valued property will be treated as a disposition requiring recapture under section 2032A(c).

  ANALYSIS. Generally, section 6166 allows an estate to pay estate tax in installments, to relieve the pressure on a closely held business to sell off assets to meet its estate tax bill. Under section 6166(g)(1)(A), however, the installment payments become due immediately if 50 percent of the business is sold, or if 50 percent of the net assets are withdrawn from the business. Noting that section 6166 is intended to preserve a business' life, and that the instant estate's sale was necessary to keep the farm operating, the Service held that section 6166(g)(1)(A) does not apply, provided that all the sale proceeds are applied to reduce the mortgage debt on other assets of the ongoing business. Sales proceeds exceeding the outstanding mortgage, the Service said, must be added to other dispositions to determine whether the 50 percent ceiling has been met.

  With virtually no discussion, the Service held that the sale of the farmland will be subject to section 2032A(c) recapture tax. 'Unlike section 6166,' the Service said, 'section 2032A is focused on real property, and requires the continued dedication of the specially valued real property to a qualified use.'

ISSUES

  1. If there is a sale of a portion of the assets of a closely held business to allay impending foreclosure and all the proceeds are applied to reduce mortgage debt on encumbered assets of the ongoing business, has there been a disposition of an interest in the business or withdrawal of funds from the business within the meaning of section 6166(g)(1)(A) of the Internal Revenue Code?

  2. If the sale was of qualified property specially valued under section 2032A of the Code, was there a disposition within the meaning of section 2032A(c) of the Code?

FACTS

  D, the decedent, died in 1983. At the time of D's death, D had owned and operated a farm as a sole proprietor for more than 10 years. The farm consists of 2 separate tracts of land, each encumbered by a mortgage. Tract A had a fair market value of $700,000 and was encumbered by mortgage and accrued interest of $400,000. Tract B had a fair market value of $500,000, and was encumbered by a mortgage and accrued interest of $300,000. The adjusted value of the farming business was $550,000. The adjusted gross estate was $700,000. The executor elected to specially value the farm real property under section 2032A of the Code. The executor also elected to defer the payment of a portion of the estate tax pursuant to section 6166 of the Code.

  In 1988, the outstanding mortgages on Tract A and Tract B had matured and were in a delinquent status. Foreclosure was imminent. However, there were insufficient cash and liquid assets to satisfy the unpaid mortgages and accrued interest which totaled $700,000. To allay impending foreclosure, Tract A was sold for $700,000 to a person who was not a qualified heir, and the entire proceeds were used to retire the mortgages on both Tract A and Tract B.

  As a result of this transaction the adjusted value of the farming business remained at $550,000, but now consisted of $500,000 in unencumbered real estate, and $50,000 representing the equity in the farm equipment and miscellaneous assets.

LAW AND ANALYSIS

  Section 6166(a)(1) of the Code provides that, if the value of an interest in a closely held business that is included in determining the gross estate of a decedent exceeds 35 percent of the adjusted gross estate, the executor may elect to pay part or all of the estate tax in 2 or more (but not exceeding 10) equal installments. Under section 6166(a)(2), only the amount of estate tax attributable to the closely held businesses may be paid in installments.

  Section 6166(g)(1)(A) of the Code provides that if any portion of an interest in a qualified closely held business is distributed, sold, exchanged, or otherwise disposed of, or money or property attributable to such an interest is withdrawn from the business, and if the aggregate of such distributions, sales, exchanges or other dispositions and withdrawal equals, or exceeds 50 percent of the value of such trade or business, then the extension of time for payment shall cease to apply, and any unpaid portion of the tax payable in installments shall be paid upon notice and demand.

  Section 2032A of the Code provides that real property used for family purposes or in a closely held business may, if certain conditions are satisfied, be valued on the basis of its current use rather than on the basis of its highest and best use under conventional rules of valuation.

  Section 2032A(c)(1) of the Code imposes an additional estate tax if, within 10 years after the decedent's death and before the death of the qualified heir --

  (A) the qualified heir disposes of any interest in qualified real property (other than by a disposition to a member of his family), or

  (B) the qualified heir ceases to use for the qualified use the qualified real property which was acquired (or passed) from a decedent.

  Section 6166 of the Code was intended to relieve the executor and the heirs from the necessity of partially liquidating a closely held business in order to pay estate taxes. The purpose of the acceleration provisions in section 6166(g)(1)(A) is to withdraw the benefits of section 6166 if 50 percent of the business is sold, or if 50 percent of the net assets are withdrawn from the business.

  In a case where the sale of encumbered assets of a business is necessary to preserve the ongoing business from creditors threatening foreclosure on those assets, treating such a sale as a disposition would not be consistent with the purpose of section 6166 of the Code. Further, such a sale does not decrease the value of the closely held business included in the estate.

  Therefore, a sale of a portion of the business assets of a closely held business that is made to allay impending foreclosure on encumbered business assets does not constitute a disposition of an interest in the business nor a withdrawal of funds from the business within the meaning of section 6166(g)(1)(A) of the Code, if all the proceeds are applied to reduce mortgage debt on other assets of the ongoing business. However, in a case in which sales proceeds exceed the amount of the mortgage and accrued interest, removal from the business of any excess funds would be a withdrawal of funds from the business within the meaning of section 6166(g)(1)(A) of the Code. Such a disposition would have to be added to other dispositions to determine if the aggregate of such distributions, sales, exchanges, or other disposition and withdrawals equals or exceeds 50 percent of the value of the interest. If so, the extension of time provided by section 6166(a) would cease to apply.

  Although the sale of Tract A does not constitute a disposition within the meaning of section 6166(g)(1)(A) of the Code, under section 2032A of the Code, any sale of specially valued property to a person who is not a qualified heir constitutes a disposition for purposes of section 2032A(c). Such a sale results in the imposition of the additional estate tax under that section. Unlike section 6166, section 2032A is focused on real property, and requires the continued dedication of the specially valued real property to a qualified use.

HOLDINGS

  1. The sale of a portion of the assets of a closely held business to allay impending foreclosure does not constitute a disposition of an interest in the business within the meaning of section 6166(g)(1)(A) of the Code, if the proceeds are applied to reduce mortgage debt on encumbered assets of the ongoing business.

  2. The sale of a portion of qualified property valued under section 2032A of the Code to a person who is not a qualified heir to pay the unpaid balance on the mortgage that encumbered the qualified property, existing at date of death, constitutes a disposition within the meaning of section 2032A of the Code, triggering the imposition on the recapture tax under section 2032A(c).

DRAFTING INFORMATION

  The principal author of this revenue ruling is Mr. Norlyn Miller of the Office of Income Tax and Accounting. For further information regarding this revenue ruling contact Mr. Miller on (202) 566-3273 (not a toll-free call).

Rev. Rul. 89-4, 1989-1 C.B. 298, 1989-2 I.R.B. 7.