Disputes about business succession can have a commensurate impact on a business’s creditworthiness. Chamberlain Hrdlicka’s Christine Borrett and Ross Holley look at the necessity of estate and succession planning for businesses ahead of time.
Estate and gift tax planning for most individual clients usually involves forming trusts, making gifts, and contemplating the IRS as a potential beneficiary. While these taxes are certainly a concern for small business owners who often lack the liquidity to cover the estate taxes out of pocket, succession planning offers other unique and pressing challenges that business owners are often hesitant to face.
Why are business founders reluctant to cede control? Many have spent their entire careers building these businesses, and it is hard to visualize what their life might look like without them, so founders tend to put off future planning. Additionally, as employees come and go, decisions about retirement and management succession continue to be put off—often until it is too late.
Other issues that come up might have to do with the successors of the business. The natural successors to a business (children, grandchildren, or business mentees) often lack the interest or skills to assume management, causing the business to fall into disarray and ultimately to be acquired, restructured, or dissolved. A widow or a widower who was not actively involved in the business when the founder was alive might find themselves in a particularly difficult position likely not in line with their own expectations for retirement.
Disputes about business succession can have a commensurate impact on a business’s creditworthiness. Lenders often are unwilling to provide credit to an organization involved in an uncertain succession dispute. Thus, without a succession plan covering this contingency, a business may find it impossible or too expensive to borrow money to cover a large estate tax bill—potentially requiring a dissolution or sale of the business, also at reduced value.
To complicate things even more, the estate tax is a classic moving target. Indeed, the last 20 years reveal that projecting a liability is essentially impossible. In 2001, the estate tax exemption amount was $1 million. Today’s exemption amount is $12.06 million. The exemption amount is scheduled and expected to decrease to approximately $6 million, with indexing for inflation, by 2026, when P.L. 115-97 (the Tax Cuts and Jobs Act) expires.
Senate Bill 994, which was supported by President Joe Biden, would have reduced the estate and gift tax exemption to $3.5 million. With this volatility, a founder who relied 20 years ago on having adequate cash reserves to pay an estate tax bill would find their plan defunct today. The potential reduction in the exemption in 2026 has renewed interest in estate tax and business succession planning today. Business owners are particularly motivated to implement certain gifting strategies and/or intra-family sale transactions now, before the retraction in the exemption amount scheduled in 2026 or interest rates increase further.
Founders may hope to rely on life insurance to cover estate tax liabilities to keep their businesses intact. Unfortunately, the cost of life insurance escalates with age, and the founder may become actually or economically insurable. Family-owned business owners are often reluctant to spend cash reserves—if there are any—on future problems when problems such as the Covid-19 pandemic pose present dangers. This delay often makes life insurance cost-prohibitive. Even if a policy is obtained early enough, there are no guarantees that the death benefit on that policy will cover the estate tax liability if projections at the time of a policy’s acquisition do not anticipate increases in the value of the business or the potential estate tax liability.
Fortunately, there are some tools that the estate of the unprepared founder can call on if the worst happens. Estate tax deferral was introduced to the Internal Revenue Code as a way help families marshal assets to help prevent them from being forced into a fire sale to pay estate taxes. The estate of a closely held business owner can defer an estate tax or pay it in installments under IRC Section 6166 or 6161. While the estate tax is generally due and must be paid within nine months of a decedent’s date of death, relief under Section 6161 allows for a 12-month extension to pay estate tax in the case of an undue hardship. Section 6166 allows for an estate that consists largely (35%) of an interest in a closely held business to pay estate tax in installments.
Payments can be deferred in the first five years and then can be paid in up to 10 installments. In most cases, interest-only payments are made during the first four years of the deferral period, and then installment payments must commence in the fifth year. But even this solution comes with tradeoffs—Section 6166, for example, requires a security interest that might complicate banking relationships.
For founders of closely held businesses, success stories in the business succession realm have a common theme: long-advanced planning with great employees. The expectation of a reduced exemption in 2026 is certainly inspiring more interest in succession planning. Business owners who would not necessarily be motivated to transfer interests to younger family members at present have found motivation to make gifts sooner rather than later, and before the Tax Cuts and Jobs Act sunsets.
Many commentators expect that the exemption amount will be retracted to at least the $6 million level in 2026, as Congress does not seem motivated to focus on relief for taxpayers with estates in excess of $6 million. Even our clients who are not ready to give up controlling interests are finding ways of transferring non-voting stock, minority interests, and cash while they can.
This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Christine Borrett is an attorney in the Houston office of Chamberlain Hrdlicka. She is board certified in estate planning and probate law.
Ross Holley is an attorney in the Houston office of Chamberlain Hrdlicka.
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