By: Martin M. Shenkman, CPA, MBA, JD
Liquidity is simply the availability of cash/funds. How readily assets can be converted to cash. The concept permeates tax, financial and estate planning. On the simplest level, you need to assure when you plan that you have adequate liquidity to meet emergency expenses, and other possible needs. The most common approach to this is the proverbial "rainy day fund". While maintaining some cash balances is important for everyone, this is almost always too simplistic an approach to the concept. The rules of thumb used to determine how much cash you need for a rainy day are often such vague generalizations that they odds are slim that they'll give you the right number. The right number depends on your personal financial situation, balance sheet, resources, income, insurance coverages and more. If you want to rely on a rule of thumb, go for it, but just pick the right thumb. If you want to be smart, complete a financial plan and come up with a real number. Also, the rainy day fund approach is usually too simplistic. Home equity lines of credit, margin accounts, family resources, and so on can all be planned for to meet emergency cash needs. Many people don't even take the simple step of securing a larger then currently necessary home equity line. Liquidity also is an important factor in a wide range of business transactions. In business valuations, negotiating shareholder agreements, and so on, the amount of liquidity, how it is defined, how it affects distributions, etc. are a vital issue. For example, many shareholders' agreements (and partnership and other agreements) include provisions governing mandatory distributions, or mechanisms to determine how cash flow can be reserved with in the entity for business expansion, working capital and other purposes. Another hot area for liquidity issues are the discounts in value claimed for gift and estate tax purposes on gifts, transfers, bequests, etc. of non-controlling interests in family limited partnerships or limited liability companies. The IRS will often maintain that if the FLP or LLC owns interests in marketable securities that these discounts are reduced, even though the asset transferred is itself a non-liquid interest in an entity subject to restrictions.
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