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Estate Tax Funding Solutions That Fit A Business Owner's Needs

Building a business is marked with many unknowns. For the successful business owner, that success has a price to be paid at death—the estate tax. This leaves a high net worth business owner to consider how to fund this obligation. There are multiple ways to pay the tax bill; finding the right solution is as much about developing an understanding of an owner’s vision for the future as it is about where the funds will come from.


Finding the Right Solution [1]

There are several ways to fund estate taxes, each with its own benefits and impediments. These options can be used either individually, or in combination with:

  • Cash

  • Life insurance

  • IRC Section 303 stock redemptions

  • IRC Section 6166 repayment plan

But before a business owner even considers any of these solutions, there needs to be thought given to larger, more fundamental questions about the future:

  • What does the owner want to have happen to the business after they are gone?

  • What does the owner want to have happen regarding the beneficiaries of their estate?

The answers to these questions need to be framed by the facts and circumstances of the:


  • What does the owner want to have happen to the business after they are gone?

  • What does the owner want to have happen regarding the beneficiaries of their estate?


  • Is there any life insurance on any of the owners (business or personal), and, if so, what are the specifics?

  • What is the degree of current family member immersion in the business?

  • Which family members will be participating in the business in the future, and which will not?

  • How will all family members be taken care of, if that’s the business owner’s wish?

  • Are there any instances where a business owner is not emotionally invested in providing for certain (or any) family member(s)?

Business and family specifics are important to understand because they can impact business continuity, who the future owners will be, and whether there is sufficient liquidity to ensure the business ends up in the right hands. It also determines which funding option is optimal. For instance, using an IRC Section 6166 repayment plan may be complicated if a business is capitalized using debt and existing lenders object to the IRS loan being prioritized over their loans. Additionally, a closely held business’s operating agreement can limit who are potential owners.


The Details

Once there is greater clarity, the conversation can focus on the specifics of technical business continuity and estate planning options.



The most immediate way to ensure the family of a closely held business owner will be able to keep the business running and pay the estate tax bill is by funding these obligations with cash. For example, for someone who is older and uninsurable, setting aside cash may be a practical solution.

Of course, any business owner considering cash funding would have to have the cash available, as well as weigh the benefits of setting aside funds with the possibility that they might be forgoing investment opportunities with higher rates of return.

While accumulating cash can be an effective way to save and prepare for estate tax needs, it can also affect the value of a business—i.e., lowering the business’s returns and financial performance calculations. So, it can be both a solution and a potential impediment.

Life Insurance:

For business owners who qualify, life insurance can be a much less expensive and more predictable way to create an estate plan that ensures liquidity when it comes time to pay taxes, particularly when it is used with an irrevocable life insurance trust. The death benefit can be used to pay the whole or a portion of the estate tax. In addition, since the life insurance death benefit provides a multiple of the premiums paid, it can dramatically increase the leverage of each dollar paid in. Depending on circumstances such as the age and rating of the insured, annual premium could total 2%-4% a year of the death benefit. One can think of it as a special interest-only loan where interest is paid in advance of the estate tax liability, with the insurance company paying out the principal (in the form of the death benefit) that never has to be paid back.

If a closely held business is owned by both a husband and wife, life insurance may be even more cost-effective. Survivorship life insurance requires two qualifying events—the death of both spouses—before a death benefit is paid, lowering premium charges.

There are a number of ways to finance a policy. The individual can pay the premium themselves or have a split-dollar arrangement between a trust and either an individual or a business. If the agreement is with a business, the way the corporation recoups its investment will depend on whether it is an economic benefit or loan arrangement. If an economic benefit arrangement is used, the corporation recoups the greater of the money advanced or the policy’s cash value. A loan arrangement, on the other hand, would repay the business the loan amount plus any accrued interest. In either case, the receivable is reflected as an asset on the company’s balance sheet. (At the death of the insured, that asset can be used to redeem stock using Section 303, described below.)

Term insurance can be a great tool as a bridge, but may not be the best option for long-term estate planning liquidity needs, due to its time-limited nature and lack of flexibility. It can help a business owner secure a life insurance contract while they are still insurable. If it is used, a quality carrier that offers conversion options with good products and realistic pricing should be selected.

Although there may be very valid reasons to use life insurance designed with a significant cash value component, the more clearly the exact goal of the policy is identified, the easier it is to pinpoint the right policy.

Policies that try to do everything may not perform as efficiently, and end up being less cost-effective. When looking to pay estate taxes, a policy designed to have less cash value can, in some cases, deliver a bigger death benefit which can be used to pay the tax bill.

Section 303 (Liquidating company stock):

This section of the Internal Revenue Code allows a corporation to redeem some of a business owner’s stock for specific purposes, such as paying estate taxes.

It allows a business to redeem just enough stock for the family to retain control of the business, pay expenses and taxes, and not risk the IRS deeming it a constructive dividend.

Note that this purchase obligation on the part of the corporation may also be funded with life insurance owned by the corporation.

Section 303 also needs to be weighed against other options, such as a stock redemption or a buy-sell agreement outside of the business, which can serve to mitigate issues between the children in the business and those that are not. A cross purchase, buy-sell agreement gives the purchaser of the business stock a new basis. A stock redemption, on the other hand, does not increase the holder’s basis, and there will be a bigger income tax bill due if the business is subsequently sold.

Section 6166 (Estate tax repayment plan):

This “fallback strategy,” provided by the IRS to help closely held businesses pay estate taxes over time, allows some financial flexibility if, for example, the business owner is uninsurable and there is a lack of liquidity, or they want to borrow money on the cheap.

Because the business is borrowing from the IRS, there are specific requirements that must be met. For instance, the federal government imposes a general tax lien on all gross estate assets which ensures that it is paid back principal and interest on the estate tax due. When there is uncertainty as to whether repayment will be made, the federal government can require either a surety bond or a special extended tax lien for the balance, and interest that extends beyond the initial tax lien. Surety bonds can be quite expensive, making them unattractive and potentially uneconomical.

There are several caveats to be aware of when using 6166. For instance, how will existing creditors react to an IRS lien? Does it break any covenants in the loans? If the business borrows to finance its operation, how will that be affected going forward? Have all owners given their consent to a lien on the business? Although a potentially effective solution, if the business is using IRC Section 6166, sufficient profits are needed to cover the loan repayment and other financial obligations.

This is the lesson the family of a successful men’s clothing business learned too late: The founder had done no estate planning, and after his death, the only viable option was a Section 6166 arrangement. However, revenues were down and the business could not cover both expenses and the 6166 repayment. As a result, the business ceased operations, and the estate was still responsible for both the repayment and the estate tax exposure for the part of the estate not associated with the business.

As a more flexible alternative, the business can also reinsure a Section 6166 agreement by purchasing a life insurance policy on the business owner. When that individual dies, the estate has the option to elect 6166 and determine the dollar amount of the election, or use proceeds from the policy to fund the liability in full or in part.

Internal Revenue Code Section 6166 is available to a closely held business owner whose active business interest totals more than 35% of the decedent’s adjusted gross estate. The decedent must be a U.S. citizen or resident and have a properly filed federal estate tax return. The provision allows the estate’s tax obligation tied to the business to be paid in annual installments. A repayment timeline is as follows:

  • The federal estate tax return for the portion of the estate not associated with the business is due nine months from the date of death.

  • A reduced, 2% rate of interest on the first roughly $1.6 million of deferred estate tax, with interest at 45% of the underpayment interest rate for the balance, must be made during the first four years after the due date of the federal estate tax return. No principal payments are required at this time.

  • Principal and interest must be made on the Section 6166 obligation during the 10 years following the initial four-year period.

The business must have enough ongoing free cash flow to service the interest payments and debt. Electing Section 6166 reduces available cash flow for the business. If the payments come out of the profits of the business, income taxes have to be paid as well. That reduces the amount available to pay under Section 6166. The business has to have profits great enough to pay both the income tax and payments due.


The Decision

When the end game is understood, and the business continuity and estate funding solutions have been laid out, a decision tree can start to take shape. This discussion should be sensitive to the emotions involved when an owner thinks about no longer being actively engaged in the business. It should also be mindful of any concern over the expense of a solution and, when possible, include family members so the owner’s wishes and strategy are clearly understood. The goal is to fully address the complexity of what is being decided—not just the means of paying estate taxes, but the future control and expectations for the business and the business owner’s family. For this reason, a team of skilled professionals need to be engaged.

Case Study:

A successful, closely held business owner had three children: a son who was actively working in the business, a second son who was peripherally involved, and a daughter who was less involved. The actively involved son was instrumental in the increase of the business’s value. He was going to be gifted and inherit more shares in the business than the other two children, but because of open communication at family meetings, everyone agreed that this made sense. There was enough insurance on the owner and his wife to pay the estate taxes for all of the children. In situations where there is not open discussion or there is active disagreement, liquidity may be needed to buy out dissident family members and the options covered above may accomplish this end.


Take the next step now . . .

An estate tax bill may be coming due upon a business owner’s death, but with the right planning early on, there will be the funds needed to pay it.

There are two key steps for estate liquidity planning:

  • Soul searching to understand what is needed and wanted for the business and family members

  • Knowledge of available solutions and which option or combination of options will meet those goals

Working with a team of professionals who understand the business, the family, and the options is essential to safeguarding a family’s financial security and a business’s continued viability. Waiting too long can scuttle a business owner’s plans and hopes, and limit solutions available to ensure liquidity. Worse still, a large, unfunded estate tax liability can kill a business and leave a family with a burdensome responsibility.

Let's connect so we can help you take the next step.


[1] This piece assumes the desire is that the business remain with the family. It does not address situations when there are family members in the business that are not children of the deceased owner. It also does not address the lifetime transfer planning that can be done to mitigate the taxes.

This material and the opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. To determine what is appropriate for you, please contact our firm. Information obtained from third-party sources are believed to be reliable but are not guaranteed.

The tax and legal references attached herein are designed to provide accurate and authoritative information with regard to the subject matter covered and are provided with the understanding that neither TRC Financial, nor M Financial Group, are engaged in rendering tax, legal, or actuarial services. If tax, legal, or actuarial advice is required, you should consult your accountant, attorney, or actuary. Neither TRC Financial, nor M Financial Group, should replace those advisors.


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