Abstract: In developing an estate plan, our primary focus is generally on determining which of our heirs will receive what assets. This is especially true where business interests are concerned. But we make a grave mistake in not considering the larger factor in the equation — namely, how much of the estate’s value will be available to the heirs. In other words, what portion of your estate is liquid vs. illiquid? This article examines estate liquidity options.
Is Your Estate Liquid Enough?
Ensure Your Heirs Receive Assets, Not Headaches
In developing an estate plan, our primary focus is generally on determining which of our heirs will receive what assets. This is especially true where business interests are concerned. But we make a grave mistake in not considering the larger factor in the equation – namely, how much of the estate’s value will be available to the heirs. In other words, what portion of your estate is liquid vs. illiquid? When you or your spouse (if you’re taking advantage of the estate tax marital deduction) dies and the time comes to pay estate taxes and other expenditures, your heirs will thank you for answering that question and leaving valuable assets – rather than financial worries – behind.
If you’re dissatisfied with your estate’s present disposition, then you’d better take action now to resolve your liquidity concerns. Let’s take a look at some estate liquidity options – for now and after you’re gone.
Liquidity Degrees
Liquidity comes in varying degrees. For instance, real estate and tangible personal assets (such as works of art, antiques and other collectibles) may be quite valuable, but the cash required to maintain them may exceed the income they generate. Other assets (such as a family business interest) may generate income, but not enough to pay the associated estate tax. Still other assets, such as your 401(k) plan or IRA, may be more valuable to your heirs if they grow long after your death. For example, a traditional IRA that holds marketable securities may be only partially liquid because of the income tax due when withdrawals are made. A Roth IRA, on the other hand, is completely liquid because no income tax is due on withdrawals.
If your estate is not sufficiently liquid at your death, your heirs will have to scramble for money to meet your financial obligations and pay the expected estate taxes – possibly even selling your assets prematurely, at below market prices, to raise the cash. In light of the uncertainty of a permanent estate tax repeal following the enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), it is still advisable to plan for the likelihood that federal estate taxes will eat up as much as 55% of your estate (the top estate tax rate in 2011 and beyond if Congress doesn’t extend EGTRRA’s estate tax provisions).
Reasons and Resources
Your heirs will need sufficient liquid funds to satisfy the following financial obligations that may arise shortly after your death:
o Funeral expenses, including a grave site marker or monument,
o Outstanding debts and liabilities, including any medical expenses,
o Continued living expenses for family members dependent on you as the breadwinner,
o Estate and inheritance taxes, which are generally due nine months after death, and
o Estate administration and settlement expenses.
With this in mind, calculate your loved ones’ anticipated cash flow needs. Then determine your estate’s current level of liquidity. Keep in mind that your estate may consist of one or more liquid assets that will be available to meet your family’s anticipated needs. Common sources include:
o Cash, bank funds and readily marketable securities,
o Life insurance proceeds, and
o Real estate investments – such as a commercial building or residential apartments – that generate a steady stream of rental income.
Another source for potential liquidity is the buy-sell agreement in your closely held business. If your estate includes closely held business interests, a proper buy-sell agreement will guarantee that your heirs receive fair value for your business interest. The agreement should also set forth terms for selling your interest to the remaining owners or for allowing the business to redeem your interest. Typically, buy-sell agreements are funded by life insurance, which provides the liquidity for effecting the buyout.
Deferral on Business Interests
One late-in-the-game option to defray, but not reduce, heirs’ financial obligations is to take advantage of deferred estate tax payments if at least 35% of your estate’s value consists of a closely held business or family farm. Your executor may elect to defer payment of the estate tax attributable to that business or farm interest. You elect to defer estate tax payment by checking the appropriate box on the estate tax return and attaching the notice of election to that return.
You must generally defer payment for up to five years, and then you may pay in up to 10 annual installments. A 2% interest rate applies to that portion of the estate tax deferred on the first $1.12 million (as indexed for inflation for 2003) in taxable value of the business or farm interest. All tax in excess of the 2% interest rate is subject to interest at 45% of the rate of annual interest the IRS charges for underpayment of tax, which fluctuates based on IRS tables.
There is a growing trend for the IRS to require collateral or a surety bond to secure the obligation of your estate to make the required installment payments.
If your heirs dispose of the business during the 15-year deferral period, the unpaid estate taxes are due immediately. This tax recapture provision survives estate tax repeal under EGTRRA.
Additionally, if the stock comprises 35% of the decedent’s gross estate, a closely held corporation may redeem stock from a decedent’s estate or from its heirs to pay estate taxes and administrative expenses. Such stock redemption is not treated as a disqualifying disposition for purposes of the installment payment of estate tax. This redemption is not considered a dividend as long as it’s limited to taxes and administration costs. As of this writing, President Bush’s proposal to allow tax-free dividends may give further opportunity to achieve liquidity for the estate. Check with us for the latest developments
If a family business is part of your estate, and your estate’s liquidity needs exceed your available sources of liquidity, you should take steps now to ensure that your business qualifies for the deferred estate tax payments. As part of that process, you should review and update, if necessary, your buy-sell agreement to guarantee that your business will be properly valued on your death.
Ready To Help
The advantages of using a deferred estate tax payment plan depend on the liquidity of your estate assets; the ability of your heirs to make payments and otherwise satisfy your financial obligations; and the possible returns that can be earned on the deferred tax dollars. It would behoove all involved for you to address your estate’s liquidity requirements now. Please call us; we’re ready to assist you in ensuring your estate’s liquidity needs earn proper consideration.
Back to Leisman Library Index