How Closely-Held Stock Can Help Pay Estate Taxes

We’ve all heard the stories about people who own millions of dollars of non-liquid assets who cannot pay their bills due to a lack of cash.

The heirs of your estate could be facing similar difficulties due to the potential estate taxes on your estate. While the federal estate tax is being phased out and is scheduled for repeal in 2010, estate taxes are a threat until then. And, absent further congressional action, the estate tax will return in 2011.

As a business owner, you may well be worth enough to incur a large federal estate-tax liability at your death. For those dying in 2004, taxable estates of more than $1.5 million are generally subject to federal estate tax (up from $1 million in 2003). Taxable estates valued over that amount are subject to tax rates of up to 48%.

Yet, your estate may contain comparatively little of the cash needed for the taxes and administrative expenses that could arise. Fortunately, your estate plan can incorporate a strategy that will generate the necessary cash without a distress sale of your assets.

A Company Buyback

One strategy that is available if you own closely-held corporate stock is to arrange for your company to buy back all or part of your stock on your death to provide needed funds.

Section 303 of the federal income-tax law makes this tax-advantaged stock redemption possible. A Section 303 stock redemption will let an estate receive tax-free cash to take care of all death taxes, funeral expenses, and the estate’s administration expenses.

Ordinarily, your company’s payment in exchange for stock you own is considered a taxable dividend, subject to a top tax rate of 15%. But Section 303 can convert that distribution into a tax-favored sale of estate-held or inherited stock.

Selling estate-held or inherited stock back to the company under Section 303 is typically income-tax-free because the current tax law steps up the stock’s basis for income-tax purposes to the value on the date of its owner’s death or the alternate valuation date. If a company redeems the stock shortly following the owner’s death, no income tax would be incurred. Therefore, any gain on the redeemed stock that accumulated during the owner’s life would avoid income tax.

Qualifying for Section 303’s Tax Advantage

Your estate must meet several requirements to gain the benefit of Section 303:

• Your gross estate must include the redeemed stock’s value for estate-tax purposes. So, any class of stock owned by you at death will meet this requirement, as will stock held jointly with a spouse or stock you inherited from another individual that is includable in your estate.

• The value of the redeeming corporation’s stock included in the estate must be more than 35% of the adjusted gross estate. This is the gross estate minus taxes, losses, debts, and administrative expenses. (If your estate is too large to qualify, additional estate planning may be able to adjust your estate’s size to meet the Section 303 requirement.)

• The redemption amount cannot be more than the death taxes, funeral expenses, and administrative expenses combined.

• Generally, the redemption has to be made after your death but within three years and 90 days after the filing of your federal estate-tax return.

Will Your Company Have the Cash?

A Section 303 redemption won’t be practical unless your company can fund the buyback from your estate or heirs. The techniques available to assure enough liquidity include arranging for life insurance owned by your company in an amount that is enough to pay for the stock redemption.

We’re Ready To Help

For many business owners, a Section 303 redemption is one of several tools that can be used to ensure financial security for family members and other beneficiaries.

It is highly recommended that you consult with a professional tax advisor to determine whether a Section 303 redemption would be a desirable strategy under your financial and family circumstances. Our professionals can provide the help needed to develop a variety of estate-planning strategies for you and your family. Please call on us.

The information provided in the newsletter has been obtained from sources believed to be reliable but its accuracy is not guaranteed.