Ensure the stability of your family business and safeguard your assets with effective estate planning strategies
As Vice President of Fiduciary Services at First American Bank, I’ve seen how easily illiquid assets can be overlooked when creating an estate plan. Illiquid assets—those that can’t be quickly converted to cash—can have serious consequences for an estate, potentially disrupting a family’s financial future, creating unnecessary stress for heirs, and even attracting unwanted IRS scrutiny. For families with privately held businesses, lack of proper planning can result in forced sales of family assets, conflicts among heirs, and a failure to realize the full value of the estate. That’s why thoughtful, proactive planning is essential to protect both the family business and the integrity of the estate plan.
A Family Business with an Illiquid Estate
Imagine a family that has spent decades building a successful business, one that makes up the bulk of their wealth. This business is largely illiquid, and there are few other assets to cover estate taxes or provide liquidity to heirs. Mom and Dad have worked hard to grow the business, and now they have three children, two of whom are actively involved in the company. Their estate plan, created years ago when the business was still in its early stages, provides for an equal distribution of assets to the three children.
The challenge? Ninety percent of Dad’s estate is tied up in the family business. Without other liquid assets, an equal distribution of wealth would likely require selling the business—a move that could disrupt the future of the company. In the event of Dad’s passing, the two children involved in the business would understandably want to maintain ownership, potentially leaving nothing for the third child who is not involved in the company.
In this scenario, the impractical solution might be to liquidate the business to equalize the estate. This could lead to a "fire sale" of a key family asset, causing financial loss and potentially leading to conflict among family members. Instead, a more practical solution is to set up an Irrevocable Life Insurance Trust (ILIT) before Dad’s death. The ILIT can hold a life insurance policy designed to provide an equal share of the estate for Child #3, without requiring the liquidation of the family business.
If executed properly, this strategy also offers valuable estate tax benefits. The life insurance proceeds within the ILIT are generally excluded from the taxable estate, which can reduce the estate’s overall tax liability.
"As wealth advisors, we often see that an illiquid estate is a ticking time bomb for many families," says Karina Valido, Private Client Advisor at First American Bank. "Without proper planning, the family may be forced to sell off key assets—whether it’s the family business or real estate—just to meet IRS estate tax obligations. This can be both emotionally and financially damaging, as assets are often sold far below their true value."
Valido continues, "A well-executed estate plan—incorporating tools like the ILIT—ensures that your legacy is preserved, avoiding the need of an unwanted sale and minimizing the risk of family conflict over asset distribution."
Managing Estate Taxes: Avoiding Forced Asset Sales
Let’s say Dad’s estate triggers a $1 million estate tax liability, due within 9 months of his death. If there is insufficient liquidity outside of the business, the family might have no choice but to sell key assets—whether it's the family business, real estate, or personal property—at a significant loss to pay the tax bill.
The IRS requires payment within 9 months of death leaving the family little time to strategically organize or sell assets. This "fire sale" of assets can result in a financial loss that severely undermines the estate’s value. However, relief is available under Section 6166 of the Internal Revenue Code (IRC). If at least 35% of the estate consists of illiquid assets, the estate may defer payment for 5 years after the due date of the tax return (9 months after death). This provides a total of 5 years and 9 months to sell or liquidate assets at a more favorable price, rather than under pressure.
If more time is needed – or if the goal is to continue the business and avoid a forced sale- the estate can choose to pay the taxes in installments for 10 years, with interest applied. Essentially, this becomes a government loan, although the estate may opt to borrow from a conventional lender instead.
By deferring estate taxes over a 15-year, 9-month period, a business can avoid forced sale and buy time to make more strategic decisions. The sudden death of a business owner can be a tumultuous time for the company, particularly when issues like personally guaranteed debt, customer/vendor relations, or leadership succession arise. This uncertainty can cause profitability to dip and limit the company’s ability to borrow funds. By eliminating the demand for full repayment of estate taxes, Section 6166 gives the business vital breathing room to regroup and make thoughtful, deliberate decisions for the future.
For families that didn’t plan ahead and now face the death of a business owner, it’s still possible to mitigate the effects of illiquidity through provisions within the IRC. In addition to Section 6166, Section 303 allows for the tax-free redemption of shares from a decedent’s estate to help pay for estate taxes and related expenses. This provision is particularly useful for businesses with sufficient liquidity to redeem shares without jeopardizing the business’s financial well-being.
Together, Sections 303 and 6166 can provide valuable relief, allowing families to gradually pay estate taxes over 15 years. This gives the family time to organize a strategic sale or restructure the business, without the immediate pressure of forced liquidation.
The Role of Buy-Sell Agreements and ILITs in Estate Planning
For families with a business, particularly those with multiple owners or partners, a Buy-Sell agreement is a critical component of the estate plan. This agreement outlines how the deceased owner’s shares are transferred or sold, often funded by life insurance policies. However, a recent court ruling—the Supreme Court’s decision in Connelly v. U.S.—has significantly impacted this strategy. In that case, the Court determined that the value of life insurance policies used to fund Buy-Sell agreements must now be included in the deceased owner’s taxable estate, which can increase estate tax liability.
To address this, I recommend that families set up an ILIT separate from the business entity itself. This ensures that the life insurance proceeds used to fund the Buy-Sell agreement are excluded from the estate, preventing an increase in the estate’s taxable value and helping preserve the overall financial health of the business.
The Importance of Planning Ahead for Family Businesses
The death of a business owner is never easy, but for families with closely held businesses, the financial complexities can be especially overwhelming—particularly when the estate is illiquid. Without proper planning, a family business built over generations could be sold at a fraction of its value to meet estate tax obligations.
Working with an experienced advisor to develop a comprehensive estate plan that incorporates tools like ILITs, Buy-Sell agreements, and strategic IRS provisions is the best way to ensure that your legacy is preserved. With thoughtful planning, you can avoid rushed sales of key assets and ensure that your business continues to thrive for generations to come.
At First American Bank, we are dedicated to helping families navigate the complexities of estate planning and preserving their wealth for future generations. Our team of experts is ready to work with you to develop a tailored estate plan that addresses your unique needs and goals, ensuring that your family business and legacy remain intact.
