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Effective Cash Flow Strategies for Estate Tax Liabilities

Individuals with substantial business holdings frequently encounter complex estate tax issues, which can be unexpectedly significant in cost. Failure to recognize and plan for these issues can negatively impact the estate's ability to pay its estate taxes promptly. Moreover, a lack of planning can disrupt the continuity of the business, affecting its operation as envisioned by both current and future owners. Given that complexities differ by situation, it is crucial to have a tax-efficient business succession plan tailored to maintain the business and fulfill the owner's specific intentions, thereby helping to preserve family wealth.

When creating a business succession plan, consider the following:

  • The optimal timing for transferring business interests

  • Who or what entity should receive the interests (or resulting income distributions, such as when the interests are held by a trust).

  • Whether the interests should be transferred through a lifetime gift, a lifetime sale, the owner’s estate, or a combination of these methods.

Importantly, both current and future owners should consider how to generate the cash flow necessary to pay any estate taxes due while ensuring the continued operation of the business. This article explores various tax and cash flow planning strategies specific to estate taxes, along with other issues and opportunities that can be addressed in a well-informed business succession plan.

ZSS CPAs Insight

Effectively transitioning a business to the next generation of owners through a business succession plan that incorporates estate tax planning will result in the most value being retained by the owners and their families. Whether the business is entirely family owned or has unrelated owners, each scenario comes with its own complications but with considerable overlap in planning opportunities. The business succession plan that will be most effective for the family and remaining business owners depends on many factors, including how ownership in the business is currently held, how the ownership is to be transferred, the type of industry, where the business sits in the business growth cycle, the value of the business, and available cash flow. 

Opportunities for Lifetime Transfer Planning

Current owners might consider transferring some or all of their business interests to the next generation during their lifetime. This approach provides flexibility for a gradual exit and a transition period for their successors. In 2024, the current law allows individuals to transfer up to $13.61 million in assets free from gift and estate taxes, either through lifetime gifts, their estate, or a combination of both.

However, starting January 1, 2026, the estate and gift tax exemption will essentially be halved, meaning that any value above the reduced exemption amount will be subject to a federal gift or estate tax rate of 40% (with certain states also imposing a gift or estate tax). This presents a potential planning opportunity for business owners to transfer assets and future asset growth out of their estate before 2026. These transfers could be made outright to individuals or into a trust for their benefit, extending to multiple generations, potentially leading to additional estate tax savings for successive heirs. While the trust owns the interests, trustees, investment advisors, and business managers oversee the ownership and management of the business interests, imposing some restrictions on assets and distributions to beneficiaries. Due to the inherent complexities and time required, it's advisable to start considering this type of planning sooner rather than later to ensure that transfers are executed in the most effective manner possible.

Options for Estate Tax Payment — Installment and Deferral

Even with an optimized gifting plan for an owner’s business interests, estate taxes are often still owed after the owner's death. To address cash flow concerns for both the estate and the business, several options are available to spread the payment of estate tax liability over time. These options typically prevent late payment penalties but do accrue interest on amounts paid after the original due date. They include:

  • Opting for installment payments of estate tax linked to qualifying closely held business interests as outlined in Code Section 6166.

  • An estate loan, potentially allowing for deductible interest payments; and/or

  • Requesting an extension of time from the IRS to pay the estate tax as permitted by Code Section 6161.

For installment payments:

To be an option under Section 6166, the adjusted gross estate must consist of at least 35% closely held business interests as defined by the Internal Revenue Code. This provision permits a maximum of 10 annual installments, with the flexibility to commence payments no later than five years after the original estate tax due date, thus extending the payment period for qualifying estates up to 14 years. Annual interest accrues from the original due date and must be paid accordingly. However, the deferral only pertains to the estate tax linked to closely held business interests; estate taxes unrelated to such businesses remain payable within nine months of the decedent's death.

Section 6166 deferrals will end, and the corresponding estate tax and accrued interest will be accelerated if:

  • Any portion of an interest in a qualifying closely held business is distributed, sold, exchanged, or otherwise disposed of, or property attributable to such an interest is withdrawn from the trade or business; and 

  • Overall, if such distributions, sales, exchanges, or other dispositions and withdrawals amount to 50% or more of the closely held business's value.

Certain types of redemptions are exempt from consideration when applying this acceleration rule. The estate fiduciary must annually certify that no acceleration event has occurred. If acceleration is triggered, the IRS may place a lien on business interests or assets, as well as potentially other estate assets, until the estate tax and interest are fully paid.

Estate loan:

Another alternative is an estate financing arrangement. With an estate loan, the estate can obtain the necessary funds to settle its estate tax obligations promptly, repaying the loan gradually according to the agreed terms. The interest paid throughout the loan's duration may be deductible on the estate tax return, provided that all of the following conditions are satisfied:

  • Prepayment of the loan is not permitted;

  • The interest must be paid at a fixed rate;

  • The estate lacks liquidity; and

  • The deduction is permissible under the laws of the state where the estate is being administered.

Request for payment extension:

Section 6161 grants the IRS the authority to extend the time for paying estate tax under specific circumstances. This provision allows for a total extension of up to 10 years, granted in one-year increments, based on a showing of "undue hardship" for the estate. While a Section 6161 extension is not typically part of planning strategies, it can serve as a fallback option if other payment deferral avenues are not viable.

Financing Estate Tax — Cash Flow Management:

Despite the potential to utilize installment payment options for estate tax, it's prudent to explore additional cash flow planning strategies to ensure sufficient funds are accessible for timely tax payments. Commonly available options include:

  • Buy-sell arrangements (potentially supported by life insurance proceeds);

  • Life insurance policies; and/or

  • Non-business holdings.

Buy-sell agreements:

A buy-sell agreement establishes conditions whereby a business and/or its owners are either obligated or have the option to buy out another owner's stake following a specified event, typically including the death of the concerned owner.

In family-owned businesses, interests are typically gifted to relatives, reducing the need for buy-sell agreements. However, when buy-sell funding is envisaged, determining the purchase price is crucial. Although the parties are bound by the agreement's price, the IRS might assert a different fair market value for estate tax purposes. If the agreement's value doesn't align reasonably with the IRS's valuation, proceeds received may fall short of the assessed estate tax value. To prevent valuation disputes, buy-sell agreements should establish a fair market value purchase price based on tax principles.

When drafting these agreements, caution is necessary to avoid unintentionally accelerating the estate tax due date, potentially shortening a 14-year deferral. Life insurance can partially fund buy-sell agreements. In a cross-purchase agreement variant, each owner holds a policy on others, ideal for businesses with few owners.

If the business holds life insurance, it's vital to structure the arrangement to exclude insurance proceeds from the estate tax value upon the owner's death. The IRS assesses whether the arrangement aligns with industry standards and agreement terms to determine its legitimacy. Deviations may impact the case to exclude insurance from the estate tax value.

In Connelly v. United States, the U.S. Supreme Court heard arguments regarding life insurance proceeds' inclusion in the estate tax value of a business. The court denied an offsetting reduction for the business's requirement to redeem shares from the estate, as the buy-sell agreement terms weren't followed.

ZSS CPA's Advisory

To prevent unintended and potentially expensive issues, parties involved in a buy-sell agreement should ensure strict adherence to all agreed terms. The agreement must also comply with the intricate tax regulations governing the valuation of business interests for estate tax purposes. Furthermore, its terms should mirror those of comparable arm's length arrangements. Additionally, taxpayers should stay informed about the Supreme Court's decision in Connelly, as it will offer further insights into the utilization of buy-sell agreements with life insurance funding in estate tax planning.

Life insurance arrangements:

We offer various opportunities to finance estate taxes. Families may opt for an irrevocable life insurance trust, while other owners might consider business-owned life insurance, a business life insurance entity, or a cross-purchase agreement. Typically, life insurance doesn't cover the entire estate tax liability for a high-growth company, so installment payments should be considered alongside this option.

Non-business assets:

We held by the business or estate, such as money market accounts or other investments, may not be essential for business operations. Liquidating these assets, where feasible, can help finance the estate tax.

Balancing Gifted Shares in Family Enterprises:

One crucial aspect for family businesses is the owner's preferences regarding distributing gifts among children equitably. Shares in family enterprises are often transferred via gift or trust to surviving family members, either evenly or solely to those actively engaged in business operations. Establishing clear business governance and managing beneficiary expectations are vital to prevent or minimize potential family conflicts regarding business management and the planned transfer of ownership.

For instance, if one child works in the business while others do not, complications may arise regarding how the owner intends to distribute the business among their children. Business owners may desire the shares to be:

  • Equally distributed among all their children;

  • Transferred solely to the child actively involved in the business, while other assets of comparable value are transferred to the siblings.

  • Transferred to one or more children without ensuring equal distribution.

Furthermore, rights of first refusal may be conferred, enabling the children involved in the business to purchase their siblings' interests. Business owners should collaborate with their advisors to craft a business succession plan that not only incorporates gift and estate tax planning but also considers the goal of preserving family unity for successive generations.

How ZSS CPA's Can Help:

Incorporating estate tax and cash-flow strategies into business succession planning ensures the business's ongoing success while minimizing taxes for the owner and their estate. With the current heightened gift and estate tax exemption until 2025, there's a limited opportunity to transfer assets and growth out of a business owner’s estate, potentially reducing future estate tax obligations and enhancing the prospects of a smooth business transition.

ZSS's private client services professionals possess extensive consulting experience across various industries and global landscapes, making them well-equipped for business succession and estate tax planning. ZSS can assist in developing and executing a tax-efficient business succession strategy aligned with the owner's objectives, while also safeguarding the business's value and the family's wealth. Contact ZSS for further insights into estate and wealth succession planning.

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