Strategies for acquiring the liquidity needed for the payment of estate taxes can be handled three ways:
- By deferral: Estate taxes on the value of the business interest may be able to be paid over a period of up to 14 years, if the business interest is more than 35 percent of your adjusted gross estate. The business may be in the form of a proprietorship, a partnership or a corporation. Of course, the IRS will charge interest at a rate set by law. In effect, Uncle Sam becomes your banker.
- By redemption: The redemption of closely held stock of a corporation is a planning technique that can allow your heirs to maintain control of the company and gain liquidity to pay taxes. Stock can be redeemed with capital gain treatment to the extent that the proceeds of the sale of the deceased's stock are used to pay administrative and funeral expenses. This is an important distinction because without it, the redemption can be treated as a dividend and the entire proceeds (not just excess over basis) would be taxed as ordinary income. To qualify, the 35 percent of gross estate test must be met and the beneficiary must share liability for tax and debts of the estate. Moreover, the company must have enough cash to redeem the stock. Combination of redemption with the 14-year deferral provision is a tricky tactic for which you will need to hire a very talented attorney.
- Through buy/sell agreements: Buy/sell agreements can provide liquidity when the purchaser has funded the purchase price with life insurance on the decedent's life. The other advantages of a buy/sell agreement include the fact that it's an organized plan for the disposition of the business interest. It can also establish a value which is always a problem in the case of a closely held business. The agreement can be between the business and its owner (a redemption plan) or among the various owners (a cross-purchase plan.) Frequently, the agreement will be backed by life insurance policies on all the principals, so a ready supply of cash will be there when needed. In a partnership, a buy/sell agreement is like a pre-nuptial agreement between the partners. For corporations, it's an attempt to set future value on some rational basis that may well hold up during IRS scrutiny. The tax benefits of a buy/sell agreement depend largely on careful drafting so a very good lawyer will be necessary if this strategy is used.