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For years, decades, or generations your family has operated a business that has provided high-quality goods or services or for your neighbors, friends and other clients. But, times change and nothing can last forever. Perhaps an unexpected illness or injury made keeping up with day-to-day operations impossible. Or perhaps you simply reached the limits of the business’ potential growth under your stewardship. You believe that a management firm with greater resources can bring the company to the next level.
Whatever your exact reasons for considering selling the family business, you undoubtedly want what is best for your company and its employees. You may also realize that you can sell the company to one or more of your children to protect the business’ mission and keep the company in the family. However, the short-term needs and goals of the selling parent and purchasing child are not necessarily aligned. Without careful consideration of the tax implications of the sale of a closely held family business and particularly when the selling parent dies before he sale can be completed, a tax trap that can affect the purchasing child, the estate, and all who benefit can be created.
Incompetency and death are extremely difficult to predict. However, death represents the triggering event that will show whether preparations for this eventuality were sufficient. While some business owners may consider their eventual death, that does not mean that they necessarily take appropriate action or meet with an attorney who can address these end of life concerns.
To illustrate this point, let us consider a hypothetical estate plan. In the plan, the family business is to be transferred through an installment sale over the course of many years to one of the children. However, before the sale can be completed, the parent who owns the business passes away. In the will, there was a provision that stated, in the event of the parent’s death prior to the completion of the sale, the remaining debt will be forgiven. The parent probably thought that he or she was doing their child a favor by including this provision, but in reality such action can cause wide-ranging tax problems for the estate and for the child purchasing the business.
Let’s say that the installment sale was to be completed over the course of 20 years. Let us assume that the parent who owns the company decides to sell the business to his or her daughter. But, the parent dies eight years into the installment payments for the company. When the remaining 11 years of installment payments are forgiven per the terms contained in the will, the forgiven amount is considered income in respect of a decedent (IRD). Income in respect of a decedent is taxable income and represents a tax burden for the estate. If the will fails to state that this tax liability will reduce the purchasing child’s share of the estate, this will create a secondary tax problem for the child individually and a potential problem of fundamental fairness in the division of the estate..
To be clear, these problems occur chiefly when the selling parent dies before the sale can be completed. Insufficient estate planning can create or compound the issues already discussed. But, one of the most simple and straightforward ways to correct at least the inequitable distribution problem is to provide language in the will that specifies how taxes will be apportioned among the beneficiaries. This type of provision can provide that the taxes due to loan forgiveness will be deducted from the benefitting individual’s share of the estate. When there are multiple beneficiaries, this can ensure a more equitable distribution of the estate.
Another option that a selling parent and purchasing child can pursue are a self-canceling installment note or a private annuity. The self-canceling note is intended to be rendered null at the selling parent’s death. Because the debt is canceled at death, this type of note typically will carry a higher interest rate or other concessions to offset this fact. However, the valuation of a self-canceling installment note can be difficult. A valuation that differs significantly from the IRS’ expectations, can raise suspicion and result in a tax audit or a tax investigation. While other options to address this tax trap are available, business owners should not take action without first consulting with a tax professional.
The attorneys and CPAs of Tax Law Offices of David W. Klasing are experienced in both tax matters and in estate planning concerns. If you are contemplating the sale of a closely held family business to a child or another party, it is prudent to discuss the potential tax problems this sale can create prior to taking any action. To schedule a reduced-rate consultation, call us at 800-681-1295 today or contact us online.