Estate taxes are generally due nine months after the date of death – and they are due in cash. How can you be sure the money will be there when it’s needed, or at the very least reduce what is owed?
There are four common main sources of funds to pay estate taxes:
- Current savings and investments.
- Borrow the money
- Life Insurance
However, sometimes savings and investments may not be sufficient. Borrowing could leave your survivors strapped during a stressful time, and liquidation may not always be enough.
More on Life Insurance Tools
Life insurance can provide a timely death benefit, in cash, that can be used to pay estate taxes and other costs. And it will be paid directly to the beneficiary of the policy, without being subject to the time and expense of probate.
Fortunately, life insurance premiums can be looked at as a systematic way of funding future estate taxes. You get guaranteed liquidity and a death benefit that is generally free from federal income taxes. Indeed, the financial protection provided by life insurance can be invaluable to those who have the burden of paying estate taxes — your loved ones.
An irrevocable life insurance trust is an alternative insurance tool that is often used to keep the insurance proceeds from being subject to estate tax at your death. There are costs and expenses associated with the creation and operation of a trust, so please speak with your financial planner to help weigh the pros and cons.
Reduce Estate Taxes Via Family Limited Partnership
For those whose wealth is generated through a family business, there is an alternative posture to consider. A family limited partnership (FLP) is a partnership created and governed by state law and generally comprises two or more family members. As a limited partnership, there are two classes of ownership: the general partner(s) and the limited partner(s). The general partner(s) has control over the day-to-day operations of the business and is personally responsible for the debts that the partnership incurs. The limited partner(s) is not involved in the operation of the business. Also, the liability of the limited partner(s) for partnership debts is limited to the amount of capital contributed.
An FLP can be a powerful estate planning tool that may:
- Help reduce income and transfer taxes
- Allow you to transfer an ownership interest to other family members while letting you keep control of the business
- Help ensure continued family ownership of the business
- Provide liability protection for the limited partner(s).
Generally, an FLP is often formed by a member(s) of the senior generation who transfers existing business and income-producing assets to the partnership in exchange for both general and limited partnership interests. Some or all of the limited partnership interests are then gifted to the junior generation. The general partner(s) need not own a majority of the partnership interests. In fact, the general partner(s) can own only 1 or 2 percent of the partnership, with the remaining interests owned by the limited partner(s).
There are several advantages to organizing your business as an FLP:
- Limited partnership interests that are gifted to other family members are generally valued at less than the full fair market value of the underlying assets. That is, reasonable discounts to the value of the limited partnership interests are permitted for lack of marketability and lack of control. This means that by gifting the assets via a limited partnership interest instead of an outright transfer of the business assets themselves, you may be saving both gift and estate taxes.
- At death, only the value of your ownership interest in the partnership will be included in your gross estate.
- The use of the partnership entity allows you to shift some of the business income and future appreciation of the business assets to other members of your family.
- You maintain management control of the business while transferring limited ownership of the business to family members.
- Restrictions within the partnership agreement limiting the transfer of the partnership interests may help ensure continuous family ownership of the business.
Coping with estate taxes may be a difficult proposition for you or your survivors to even consider. When it comes to funding sources to pay them, talk with your wealth manager to discuss alternative life insurance tools or generational business planning.
Sources: Broadridge Investment Management Solutions
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