For many owners of closely-held businesses, their business is by far their most valuable asset. Given that both the federal and New York State estate tax seem destined to be with us for the foreseeable future, it is imperative that owners of valuable business interests carefully consider the potential impact of estate taxes on the survival of their business to the next generation.
Business interests – typically in the form of closely-held stock or limited liability company interests – are inherently illiquid. But when a business owner dies, the fair market value of such business interests will be included as an asset of the owner’s estate, notwithstanding such illiquidity. To satisfy the IRS and New York State that the business is valued accurately, the value of the business interest should be determined by an independent business appraiser. If the value of the business interests combined with the business owner’s other assets exceeds the estate tax exemption amounts – presently $3.5 million under federal law, $1 million for New York State – then property in excess of those amounts that pass to someone other than a spouse will be subject to estate tax. If the estate does not have liquid assets to pay the tax, then the heirs could be in a real bind. Estate tax payments are payable – in cash – within nine months after death. If not timely paid, significant penalties and interest will accrue.
Take the following example: In 1967, Louie Lucky started a medical supply business – Lucky Louie’s Medical Supply, Inc. (the “Corporation”). Over the years Louie’s business grew into a regional powerhouse. Like many owners of closely-held businesses, Louie poured most of his profits back into his business. When Louie turned 65, his business attorney and CPA advised Louie that he needed to do some serious estate planning. Louie brushed them off and found an excuse to change the subject.
Louie had married his high school sweetheart, Mary, in 1965. When Louie began the Corporation, his attorney issued stock certificates in Louie’s name only. Louie and Mary had three children, Robert, Michael and Nancy. Of the three children, only Robert worked in the business, starting as a salesman and eventually moving into a management role.
In 2005, Mary died suddenly of a stroke. Louie began taking a less active role in the business, with Robert assuming day-to-management of the company. Louie, however, retained all the stock in the Corporation. Despite Robert’s frequent nagging, Louie never got around to working out a business succession plan.
Louie died of a heart attack in 2009. His assets include a home in Orange County worth $500,000; a brokerage account with $500,000 in stocks and bonds; bank CD’s worth $300,000; and his stock in the Corporation. Louie’s will, which he signed in 1990, provided that if Mary predeceased him, all of his assets were to pass among his three children in equal shares. In his will Louie named Mary as the primary executor, with Robert and Michael to serve as successor co-executors.
The attorney retained to help administer Louie’s estate advised Robert and Michael that they needed an appraisal of Louie’s stock in the Corporation to determine the amount of estate taxes to be paid. The appraiser came back with stunning news: Louie’s 100% interest in the Corporation was worth $8 million. Combined with his other assets, Louie’s taxable estate was worth $9.3 million.
Since Mary had predeceased Louie, there was no opportunity to take advantage of any portion of the “unlimited marital deduction.” Accordingly, the full value of Louie’s estate was subject to estate tax. Michael, Robert and Nancy were astonished to learn that the combined federal and New York State estate tax on a $9.3 million estate for a decedent dying in 2009 is $3,633,260. Since Louie had only $800,000 in liquid assets at the time of his death, the children faced a liquidity shortfall of approximately $2.8 million needed to cover the estate tax. Even if they could find a buyer for the Corporation after Louie’s death, they would almost surely have to sell it at a “fire sale” price in order to timely pay the tax within the nine months of Louie’s death, and Robert’s dream of continuing his father’s legacy would be shattered.