Parents who have built a successful business and raised capable children might find the proposition of selling the family business to the children compelling.
As with so many decisions in life, there are pros and cons to this proposition, but structuring the transaction well is still vital.
Initially, parents should carefully consider the business and the actual prospect of a qualified heir to take over the business. The reality is that only 30% of family businesses survive a second generation and as few as 15% survive a third generation (Dwight Drake, Closely Held Enterprises, 314, 2018).
If the parents are confident that their offspring includes the right person to take control of the business and allow it to thrive, then the transition strategy can be developed.
The concept of selling the business to children is significantly different from selling to third parties.
Parents are often encouraged to explore favorable terms of sale for non-monetary reasons (e.g., keeping the business in the family, helping the child or children, as a sort of reward for the child’s efforts to date, etc).
In other words, a parent often tries to set up a sale that makes it easier for the child to buy while still offering a respectable sale price (albeit sometimes well below “fair market value”) for the parents.
Often, the sale of the business is also used to create the necessary cash to finance the inheritance of other children who are not involved in the purchase of the business.
Gift rules apply
A business can be gifted, but how do you determine if part of the business transition is a gift?
Whenever a person sells an asset (including the family business) below fair market value to a child, the seller must analyze the application of the gift rules (and the associated gift tax). The donation applies to the full sale price, but can also apply to other parts of the transaction, such as the interest rate charged on an installment ticket (when the parents actually lend part of the purchase price to the child buyer).
Reasonable selling price?
The responsible solution is to have the business appraised by a qualified business valuator. This allows a knowledgeable third party to assess trade metrics for an unbiased view of value. Once a clear value is established, it can then be used to later drive other components of the business transition strategy.
It is easier to know if the interest rate charged by the selling parent to the buying child is a gift. The IRS publishes the Applicable Federal Rate (AFR) monthly which is used to determine if the interest rate charged falls into giveaway territory. The long-term (nine-year) AFR for May 2022 is 2.66% (compounded annually).
Accordingly, this sets the floor for the minimum long-term interest to be charged on the sale of the business to avoid the implication of the gift rules.
Parents often structure these sales with the minimum amount of down payment, carry the loan for a longer period than a typical third-party sale, and charge lower interest on the balance of the contract.
For example, a parent trying to avoid the involvement of a gift (while creating favorable conditions for the child) may require no down payment, a 10-year installment plan, and interest of 2, 66% on the declining balance (based on the May 2022 AFR).
Although parents want to simplify the transaction for the child, parents must remain vigilant to protect their own interests from creditors.
If the parents have structured the transaction as an installment plan, the parents would be advised to maintain a security (collateral) on the property being sold.
The seller can retain a security interest in the company’s shares, accounts receivable, inventory, assets, and virtually anything that belongs to the company. Why would parents want to do this if they trust the child to make the payment?
Taking security ensures that the parents have the first right to the secured property in the event of a claim by other creditors.
So, if the business fails in the hands of the next generation and the business goes bankrupt, the parents’ wise decision to require collateral could ultimately protect some or much of the business’ value from creditors. who might otherwise be entitled to it. and keeping the business in the family.
A common misunderstanding concerns the limits of donation.
The federal annual gift exclusion allows parents to donate up to $16,000 without any reporting requirements, but parents can donate much more than that.
For example, under current law, a couple can gift a total of $22.12 million over their lifetime before being required to pay gift tax, but that couple would be required to file a federal gift return.
And, if a couple made such a large gift, it would eliminate their estate tax credit entirely, pushing any remaining assets to the 40% tax level on death. Accordingly, such an important gift should be scrutinized.
More likely, parents could choose to donate, say, $1 million out of a total business value of $5 million. Then the child has instant equity in the business and the parents can help fund the remaining purchase price of $4 million. This would also require the filing of a gift tax return, but no gift tax would be payable.
Beau Ruff, licensed attorney, is Director of Planning at Cornerstone Wealth Strategies, an independent, full-service investment management and financial planning firm.
company in Kennewick.