It's A Trap: Selling The Family Business To Your Family Could Cost You | Forbes

Steve ParrishContributor6/08/2015 @ 9:45AM

As business cycles go, this is a great time to sell a family-owned business to the family. In particular, parents can lend money to their children for the purchase of the business at an incredibly low interest rate without incurring gift tax implications. The purchasing child becomes a successor owner, and a smooth transition occurs while the parent is still alive.

Like any sale of a business, however, the devil is in the details. What looks like a straightforward sale to a child can create unforeseen taxes and can spin the family into acrimony and discord. And that’s why a sale should be well-planned and done with the help of professional advisors knowledgeable of these transactions.

As a trust officer commented to me this week, “When you have a heart attack, don’t consult a podiatrist!”

Consider this hidden tax trap. Sometimes the selling parent dies before the installment sale to the buying child has been completed. In this situation, the seller typically provides in the will for the forgiveness of the remaining debt. This seemingly innocuous move can cause income tax to the estate and an unintended financial loss to other children who are not part of the family business.

Let’s use this hypothetical. Mom, age 65, owns Famco, the family business. She has two children. Son has been active in the business for years. Daughter has not. Mom wisely realizes it is a good time to begin the transfer of Famco to Son, and she sells the business to him for a 15-year installment note. As part of the estate plan, her will provides that any unpaid balance on the note will go to son, and the remaining estate will then be split evenly between daughter and son. Simple enough, right?

Aye, there’s the rub

Even if the estate is not large enough to incur an estate tax, this arrangement can have adverse financial effects at Mom’s death.

Problem 1. Say Mom dies at age 72, leaving more than half of the balance due on the loan. When Son receives the note as a bequest in the will, the transfer is tantamount to a forgiveness of the debt. This event triggers an acceleration of income tax to the estate equal to the face of the note less Son’s basis in the note. The capital gains from the remaining balance are income in respect of a decedent (IRD) and represents taxable income to the estate. The forgiveness of the note is a trigger just as if Son had paid off the note at Mom’s death but without the offsetting funds. And, with IRD, there is no step-up in basis to save the day for the estate.

Problem 2. A compounding concern exists if the will doesn’t specifically provide that this tax will reduce Son’s share of the estate. If no such provision exists, Son and Daughter are both residuary beneficiaries of the estate and suffer the tax burden equally. As such, Daughter will have to share half of the estate’s income tax with Brother, including the IRD from the business loan. Not only does the estate suffer a tax, but there is an inequitable distribution of the estate between Son and Daughter.

Some solutions

Death is an event that is unpleasant to contemplate and difficult to predict. Yet its occurrence has a significant impact on whether an estate plan’s design is ultimately effective. For example, the scenario above is only a problem if Mom dies before the 15-year note is paid off. If she dies after the installments are complete, the IRD tax issue disappears. If, however, the issue of Mom dying during the completion of the sale is a concern, below are some ideas that may avoid the discussed concerns.

An obvious way to avoid the inequitable distribution of the tax to the estate is to include a provision in the will apportioning taxes. In other words, the will would provide that if Mom dies before the note is paid off, Son will have any taxes attributable to the forgiveness of the business loan subtracted from his remaining inheritance. That way, Son and Daughter have a more fair distribution of Mom’s residuary assets.

There are two strategies sometimes used to sell a family business that result in any remaining debt ceasing at the seller’s death. Because the debt no longer exists, there will be no IRD. One strategy is called a self-cancelling installment note (SCIN). As the name implies, the note is designed to cancel at the seller’s death. Because of this cancellation feature, some combination of a higher principal and/or interest rate is built into the calculation of the loan. Another technique is called a private annuity. In this scenario, the buyer’s payments are calculated based on the life expectancy of the seller. The duration of the payments made is totally dependent on when the seller dies. A premature death is a windfall to the buyer, whereas a longer-than-expected lifespan benefits the seller.
Both of these techniques have their own challenges. With a SCIN, the correct valuation of the payments is difficult to determine and may be a red flag for the IRS. Similarly, there are tax concerns with a private annuity – too many to describe here. And, with the private annuity, there is the issue of never-ending payments for the buyer, in this case Son. He will have to continue payments until Mom dies, even if she far exceeds her life expectancy.

A simpler solution is to have Son buy life insurance on Mom. With this approach, Mom’s premature death will trigger a tax-free death benefit that son can use to pay off the loan. While the payoff of the note is income to the estate, the estate has the money to pay the tax. Further, if Mom is insurable and this approach is employed, Mom’s will need not provide for the note to be transferred to Son at death. Rather, Son will pay off the note at Mom’s death using the insurance proceeds. As long as the taxes are properly apportioned in the will, the net estate will pass equally to the two siblings.

The sale of a family business to a child while the parent is alive is often an advisable business continuation strategy. Just be sure to structure it carefully. Attention to detail will help avoid adverse financial and familial outcomes.

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For additional information regarding Florida business sales, acquisitions and valuations, please contact Eric J. Gall at Eric@EdisonAvenue.com or 239.738.6227. Also, visit our Edison Avenue website at www.EdisonAvenue.com or my personal website at www.BuySellFLbiz.com.