How to Structure an Installment Sale With Family
| EXECUTIVE SUMMARY | |
 TO HELP FAMILY BUSINESS OWNERS BUILD A LEGACY, CPAs need to aid family members develop a plan to transfer the business organisation to the next generation while minimizing estate, gift and income taxes. Although the 2001 tax act eliminates manor taxes in 2010, at that place is no guarantee the repeal will be permanent. | |
| LEE Chiliad. KNIGHT, PhD, is professor of accountancy at the Calloway Schoolhouse of Concern and Accountancy, Wake Forest University, Winston-Salem, North Carolina. Her eastward-postal service address is knightlg@wfu.edu . RAY A. KNIGHT, CPA/PFS, JD, is a principal with Ernst & Immature LLP in Charlotte, North Carolina. His electronic mail address is ray.knight@ey.com . |
 uilding a family business into a legacy demands that families plan for succession. A business owner's key objective in developing such a plan is to transfer the greatest amount of wealth to the next generation at the least possible taxation toll. In addition to minimizing estate, gift and income taxes, the transfer too must provide the senior family unit member, who may lack sufficient resource other than the family business, with adequate sales proceeds or a lifetime income stream to proceed to alive comfortably. All in the Family In the United States, ninety% Source: UMass Family Business Eye, | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
The estate-tax-repeal provisions included in the Economic Growth and Tax Relief Reconciliation Human action of 2001 (EGTRRA) may lead some clients to believe they no longer need to plan for the transfer of a family business. As CPAs realize, however, those who dismiss estate planning because of the deed are reading the headlines just—non the fine print. Showroom ane shows the and so-called estate tax repeal doesn't take effect until 2010 and continues thereafter simply if Congress votes to override EGTRRA's dusk provisions.
The event is that consummate estate tax repeal is a remote and short-lived possibility. Thus, CPAs demand to warn clients of the danger of adopting a "expect until repeal" policy. Minimizing the estate and gift tax cost of passing the family business to the adjacent generation continues to warrant active planning. This article highlights four strategies that are capable of helping a family unit business minimize transfer tax costs as well every bit run across the needs of the senior family member: | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Each of these strategies has advantages and disadvantages that CPAs tin can explain to clients trying to develop succession plans. With the dim prospects for estate tax repeal, these techniques are little inverse and remain feasible means to preserve the family legacy. INSTALLMENT SALES Under the installment sale strategy, the senior family unit member (the business possessor) sells his or her concern to a younger family member for an involvement-bearing promissory annotation requiring a series of fixed payments, at least one of which will be received in a future tax twelvemonth. The installment method detailed in IRC section 453 automatically applies to this type of transfer unless the senior member elects out of it or it is a transaction section 453 specifically prohibits. Income tax consequences. The tax gain the senior family member recognizes each year is the gross profit portion of the installment payments he or she receives during the year. Example. Charles Canada owns a family unit business organisation with a tax basis of $200,000 and a off-white market value of $i one thousand thousand. Charles sells the business concern to his girl, Julia, in a transaction eligible for installment reporting. Charles receives $100,000 cash immediately and a promissory notation that will pay him $90,000 (plus involvement at the current market rate) at the get-go of each of the next 10 revenue enhancement years. Under the installment method, Charles recognizes $eighty,000 of the gain immediately in the first twelvemonth (80% gross turn a profit rate ($800,000 total proceeds $one,000,000 selling price) times the $100,000 cash he received). Charles recognizes the remaining $720,000 gain ($800,000 total gain – $80,000 recognized immediately) over the x-year payment period—at the charge per unit of $72,000 per year (80% gross profit rate times $ninety,000 annual payment). The senior family member also includes the interest he or she receives each year in taxable income (or must impute interest if required to do and then by the original issue discount rules of IRC sections 1271 to 1275 or by the imputed interest rules of IRC section 483 as discussed later). Sections 453(A)(b)(1) and (two) require the senior family member to pay interest on a portion of the income revenue enhancement deferred if the sales price of the business concern exceeds $150,000 and he or she, at the end of the year of auction, holds more than $5 meg of installment notes arising during the yr. This involvement, calculated at the IRC section 6621(a)(2) underpayment rate for the last month of the twelvemonth, is nondeductible personal interest to the senior family member. Using notation as collateral. The senior family member cannot accelerate cash drove on the installment sale—even if the cash comes from another source—without accelerating proceeds recognition. Section 453 requires the seller to treat the proceeds of a loan collateralized past the installment notation as a payment on the note. This means CPAs should warn clients to avert using the promissory note for collateral on a bank loan or suffer the tax consequences. Resale of business. The senior family fellow member must recognize all previously unrecognized gain if the inferior family fellow member qualifies as a related person and resells the transferred business within two years of the original installment auction. The term "related person" includes ii categories of likely recipients of a family business—children and grandchildren—just if the intent of the transfer is to preserve the family legacy, selling the business is not an option for these recipients, especially within the first two years. Disposition of installment obligation. Selling, exchanging or otherwise disposing of the installment notation also accelerates gain recognition. Transferring the note to a trustee, however, is not a disposition if the income of the trust is taxable to the senior family member nether the grantor trust rules. Thus, for estate planning purposes, CPAs tin can recommend the senior family member transfer the promissory note to a revocable trust without triggering proceeds recognition. If the junior family member cannot make the installment payments, the senior may be tempted to cancel the installment note. Counterfoil of an installment notation, still, is considered a disposition in a transaction other than a sale or substitution. Upon counterfoil, the senior family member recognizes a gain equal to the difference between his or her basis in the note (unrecovered taxation basis) and its off-white market place value (the present value of the remaining installment payments) immediately earlier cancellation. If the junior family fellow member qualifies as a related person nether section 453 (a kid or grandchild of the senior family member), the off-white marketplace value deemed received cannot be less than the face amount of the canceled note. Security interests and escrow account. The senior family member's memory of a security interest in the business does not constitute a payment nor does information technology otherwise accelerate recognition of the gain inherent in the installment payments. Funds the buyer deposits into an escrow account for future distribution to the seller, however, are considered payments unless the senior fellow member's right to receive them is bailiwick to a substantial restriction. An culling to using an escrow account CPAs tin recommend that volition not accelerate gain recognition but will provide some security to the senior family unit member is to accept the buyer secure the note with a standby letter of credit from a financial institution. This arrangement keeps the senior family fellow member from relying exclusively on the inferior family member for payment. Gift tax effects. The senior family unit member will non have to pay gift tax on the installment auction if the transfer is for full and adequate consideration. However, if the off-white value of the installment note is less than the fair value of the concern, the difference is a taxable gift under IRC section 2512. Instance. John Jackson sells a business with a fair market value of $1.2 million to his son, Eric, for $400,000 cash and an installment note with a value of $600,000. Because the total consideration received is less than the off-white market place value of the business, the $200,000 difference constitutes a gift for federal souvenir taxation purposes. Unreasonably low interest rate. Limiting the amount of interest the younger-generation family unit fellow member pays is a common objective in structuring an intrafamily installment sale. All the same this practice may create a differential field of study to souvenir tax. The original effect discount (OID) rules of sections 1271 to 1275 and the imputed interest rules of department 483 identify restrictions on setting unreasonably low interest rates in installment auction transactions. The OID rules use to the intrafamily installment sale unless the Under the OID rules, the installment note must bear interest at the applicative curt-term, midterm or long-term federal rate in event nether department 1274(d) or the seller will be deemed to have made a souvenir equal to the difference between the present value of the note based on the prevailing market charge per unit of interest under section 1274 and its nowadays value based on the stated rate of involvement (if any). The section 483 imputed interest rules cover installment sales of a family concern not discipline to the OID rules unless the sales price is $three,000 or less. Like the OID rules, section 483 imputes interest based on the applicative federal rate under department 1274(d). These minimum interest requirements for installment sales may crusade serious greenbacks flow problems for the junior family member. Therefore, CPAs need to assistance families carefully project the sources of cash available to the junior member to regularly service the installment debt obligation. Estate tax implications. The installment auction removes the family unit business and time to come appreciation from the senior family unit member's gross estate, while providing the younger-generation family member the business he or she would accept inherited later on—simply at no transfer taxation cost. However, if the note has an outstanding balance at the engagement of expiry, the senior fellow member's gross manor includes the fair market value of the installment note at the date of death or the alternate valuation date. The gross manor also includes main and interest payments the senior family member received but did not spend or transfer past gift before dying. If the junior family member makes the required payments, the installment sale will ameliorate the liquidity of the senior member'due south gross estate by removing illiquid assets and replacing them with cash and a promissory annotation. This strategy also will contribute to the senior fellow member's objective of having income to alive comfortably. Consequences to junior family fellow member. The buyer's footing in the business concern equals the principal portion of the buy price. Thus, he or she receives a step-up in basis that would not take been possible if the senior family member had transferred the business by gift. The junior family member may deduct the interest paid or accrued on the installment note unless otherwise disallowed by the IRC (for example, investment interest is subject to deductibility limits nether IRC section 163(d)(5)). Self-CANCELING INSTALLMENT NOTE Using the self-canceling installment note (SCIN) strategy, the senior family unit member sells the business organisation in exchange for the inferior family fellow member'south hope to make periodic payments until the senior member receives the sales toll or dies, whichever occurs showtime. The SCIN, therefore, is a contingent payment installment sale. The contingency is that the seller's death will occur before the notation matures. To recoup the senior family member for the risk of the note's cancellation, the SCIN includes a "take a chance premium" reflected in a college sales price (the principal balance due on the note) or a higher involvement rate. The IRS, in general counsel memorandum 39503, says the period for receiving the sales price of the business must be less than the senior family unit fellow member'due south life expectancy to avert private annuity handling. Income tax consequences. If the SCIN transaction qualifies for installment auction treatment, the senior family member tin report the proceeds—calculated assuming receipt of the maximum sales price—over the period he or she receives payments. In calculating interest under the OID or the imputed interest rules, the senior assumes payments volition be accelerated to the earliest possible date the agreement allows. Each payment represents a return of basis, capital letter gain and interest income. Another acceleration of gain outcome. The events triggering gain recognition nether the installment sales method—resale of the concern within two years if the junior family member is a related party, using the annotation equally collateral for a loan, disposing of the note and paying funds into an escrow account—employ equally to a SCIN. But the SCIN adds another gain acceleration caveat: the death of the senior family member before all payments are received. As established in Frane , 998 F.2d 567 (8th Cir. 1993), this gain is reported every bit income in respect of a decedent on the estate's income tax return.
Consequences to junior family member. Like the installment auction strategy, the SCIN allows the inferior family member to become a stepped-upwards basis even if the senior family member dies prematurely. Too, the child or grandchild can deduct the interest paid or accrued on the installment note unless the IRC says otherwise. The risk premium itself also may provide taxation advantages to the inferior family unit member. If the premium is reflected through a college interest rate, the interest deductions available to the junior family member will be higher. Alternatively, if the parties are willing to assign a higher sales price to the SCIN to reflect the hazard premium, the junior family unit member may acquire the optimum supportable basis in the private assets of the business organization, thus maximizing depreciation. The increased ground also volition reduce the proceeds the new possessor reports on a subsequent disposition of the belongings. Souvenir tax effects. If the value of the self-canceling note the seller receives from the junior family member is less than the off-white market value of the business, the difference is a taxable gift under section 2512. The parties usually can avoid this treatment if the values they rely on are reasonably authentic and they utilise special care in ensuring the risk premium the heir-apparent pays for the cancellation feature is realistic. If the parties use the IRS life expectancy tables, which reflect an increasing hazard premium as the seller's age and the term of the note increase, to make up one's mind the chance premium, this ordinarily satisfies the special care standard. In situations where death is imminent, however, the tables don't apply (revenue ruling fourscore-fourscore, (1980-1 CB 194)), and the IRS will judge the reasonableness of the risk premium by because the amount of the down payment, the length of the contract and the seller'due south actual health. Manor revenue enhancement implications. If properly structured, the value of the canceled obligation under the SCIN volition not be included in the senior'southward estate for federal estate tax purposes. This handling assumes the entire annotation, including the self-cancellation feature, resulted from bargaining between parties in equal positions and the buyer paid an acceptable premium for the feature. As with the regular installment sale, the senior family member'due south estate includes SCIN payments (principal and involvement) received but unspent at death. The longer the senior member lives, the more funds he or she will accrue. If the senior lives for an extended period of time, the regular installment sale strategy will provide ameliorate manor revenue enhancement results considering the annual payments volition not include a risk premium. Unfortunately, clients must make up one's mind which strategy to apply at the time of the transfer. CPAs should warn clients that afterwards events (premature expiry, living longer than expected) might change the event of a particular strategy. Individual ANNUITY Using the private annuity strategy in IRC section 72, the senior family member sells the business in substitution for the junior family member's unsecured promise to make periodic payments for the duration of the senior's life. The transaction is characterized as a private annuity because the junior family unit member is non in the business of entering into annuity contracts commercially. A private annuity fits literally inside the definition of an installment sale (a disposition of property where at least one payment is received after the shut of the tax year of disposal) and may be structured like a SCIN (the periodic payments continue until a specified budgetary amount is reached or the senior family fellow member dies, whichever occurs first). The legislative, judicial and administrative history of the two strategies, withal, indicates the tax police force does not treat them the same style. Section 72 governs private annuities and section 453 governs installment sales. To distinguish the two strategies, the IRS, in general counsel memorandum 39503, established the bright-line test referred to earlier: | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Income tax consequences. The IRS spells out its position on the income tax treatment of private annuities in acquirement ruling 69-74 (1969-1 CB 43). Recognizing that a individual annuity contains elements of both a sale and an annuity, it requires the seller to classify each annuity payment between a capital amount (farther broken down between a recovery of basis and capital gain) and an annuity amount (taxed equally ordinary income). To reach this allocation, the senior family unit fellow member must follow a iii-step process (see case in exhibit two).
Step one. Summate the percent of each annuity payment excluded from income until the senior fellow member recovers his or her ground in the business. This percentage, referred to as the "exclusion ratio, is calculated past dividing the senior's investment in the contract (adjusted ground in the business) by the full expected return (annual payment multiplied by the senior'south life expectancy determined using the tables in regulations department one.72-9). The dollar corporeality excluded is merely the exclusion ratio times the annuity payment. Step two. Calculate the percentage of each payment taxed equally a majuscule gain past dividing the total gain by the expected return or past multiplying the ratio of the upper-case letter gain to the expected return times the annuity payment. The total capital gain is the difference betwixt the senior's adjusted footing in the business and the present value of the annuity (using the estate and gift revenue enhancement tables IRC section 7520 requires). The dollar amount of capital gain is simply the capital gain percentage times the annuity payment or the total capital gain divided by the senior's remaining life expectancy. Thus, the senior pays capital gain taxes on the capital letter proceeds portion of each payment for the duration of his or her life; thereafter, the proceeds portion is taxed at ordinary income rates. | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
| Step 3. Calculate the portion of each payment taxed as ordinary income for the duration of the senior'due south life by subtracting the excluded portion and the capital gain portion. The senior family member who secures the annuity normally volition exist taxed immediately on the gain (run into Manor of Bell five. Commissioner, threescore TC 469 (1973) and 212 Corporation 5. Commissioner, 70 TC 788 (1978)). Moreover, if the inferior family member tin't make the annuity payments, the senior member may not benefit from writing off the residue of his or her footing. If the loss is accounted a capital rather than an ordinary loss, as the Revenue enhancement Court held in Mcingvale 5. Commissioner, TC Memo, 1990-340, aff'd, 936 F2d 833 (5th Cir. 1991), the senior member must take capital gains against which to commencement the upper-case letter loss to benefit from the writeoff. Thus, if the private annuity is to be a viable strategy for transferring a family concern, the junior family unit member's ability to make the payments should exist certain. An advantage of the private annuity over the SCIN is that canceling the obligation does not trigger gain recognition. (General counsel memorandum 39503.) However, it will be hard for the senior member to cancel the obligation without gift tax consequences. Based on individual letter ruling 9513001, the IRS will debate that counterfoil indicates the senior member never expected to receive or enforce the annuity payments. Thus, the annuity was not a bona fide business transaction. CPAs should warn clients that the income revenue enhancement benefits of canceling the obligation will stake in comparison to the gift tax obligation if the IRS successfully enforces this claiming. Consequences to junior family member. Revenue ruling 55-119 spells out the IRS position on the basis of the property to the purchaser. For depreciation purposes, the ruling says the purchaser's ground before the seller dies is the nowadays value of prospective payments, using the stipulated life expectancy tables. The purchaser adds any payments exceeding this value to the basis as they are made. At the seller'southward death, the purchaser'southward footing in the property equals the total annuity payments made. Dissimilar with installment payments where involvement may be deductible, the junior family member cannot deduct any part of the annuity payments. This rule runs counter to the senior member's treating part of each payment equally ordinary income—in issue, interest—just is well established in case law (see Bell v. Commissioner, 76 TC 232 (1981), aff'd, 668 F.2d 448 (8th Cir. 1982); Dix v. Commissioner, 46 TC 796 (1966), aff'd, 392 F.2d 313 (fourth Cir. 1968)). Thus, the inferior family fellow member treats each payment as entirely principal—an increment in basis. However, this provision as well ways the junior member must be able to make the annuity payments without a revenue enhancement deduction. Souvenir tax effects. No gift tax arises with the private annuity strategy if the fair value of the family business is roughly equivalent to the annuity's present value. If the fair value of the business exceeds the present value of the annuity, however, acquirement ruling 69-74 requires the senior to treat the backlog every bit a gift to the junior. Besides, if the annuity's present value exceeds the fair value of the concern, revenue ruling 69-74 requires the junior family unit fellow member to care for the backlog equally a gift to the senior member. Either party may use the annual gift revenue enhancement exclusion to reduce the taxable gift. Estate tax implications. The major tax benefit of a private annuity is that the business volition not be office of the senior family unit fellow member'due south gross estate. Additionally, since payments cease at the senior fellow member'south death, no income in respect of a decedent exists. All the same, as with the regular installment sale and the SCIN, the senior's estate volition include annuity payments received just not expended as of the date of decease. GRANTOR RETAINED ANNUITY TRUST Using the grantor retained annuity trust (GRAT) strategy, CPAs can advise the senior family fellow member (the grantor) to transfer the business to an irrevocable trust, retaining an income interest for a specified number of years. When the trust term ends, the business passes to the inferior family member (the balance beneficiary). Thus, a GRAT gives the senior member an income stream from the business for a period of years while he or she continues to control it. Income revenue enhancement consequences. For income taxation purposes, IRC section 677 considers the GRAT a grantor trust and thus continues to treat the senior fellow member as owner of the belongings transferred to the trust. Accordingly, he or she recognizes no gain when placing the business into the trust and reports no income upon receipt of the annuity payments. Instead, the senior member pays taxes on all income the trust earns. The parties may structure the trust so that in a given tax twelvemonth the excess of tax paid on trust income over the annuity payment is distributed to the grantor. The IRS hinted in letter ruling 9444033 that it considers the taxation the grantor paid on trust income a souvenir to the residuum casher. The IRS, notwithstanding, provides no legal back up for its position and the senior family member can fence that excess income in one year will not necessarily be passed (gifted) to the junior family unit fellow member. The trust may need this backlog to pay the annuity in a yr where income is less than the required annuity payment. Also, since the senior member recognizes no proceeds on transferring the business organization to the trust, information technology'south only logical the inferior family member receives the business with a carryover basis. Thus, provided the senior prevails in this state of affairs, a GRAT offers the benefit of an indirect souvenir to the inferior family member without gift tax. Gift taxation effects. While the senior has no taxable proceeds upon transferring the concern into trust, a taxable gift arises at this indicate. The value for souvenir tax purposes is the difference between the fair value of the business and the present value of the retained annuity payments. The annuity discount period is the shorter of the annuity term and the senior fellow member'southward expected life. The disbelieve rate, established in section 7520, is 120% of the federal midterm rate for the calendar month the senior puts the business in trust. Because contributing the business organisation to the GRAT is a future interest, the contribution is not eligible for the $10,000 almanac souvenir revenue enhancement exclusion. Thus, the entire value is subject to gift tax. However, CPAs know the tax can be reduced to a nominal amount by minimizing the souvenir value—accomplished through some combination of extending the term of the trust, establishing the GRAT at a younger age and increasing the size of the annuity. These actions volition enhance the present value of the retained annuity payments, thus decreasing the value of the souvenir. By minimizing the gift tax paid, lilliputian will be lost if the senior member dies in 2010, the 1-year window for no estate tax nether EGTRRA. Manor tax implications. The major benefit of a GRAT hinges on whether the senior family member tin exclude the trust property from his or her estate. If the senior member survives the annuity term, the family will realize this benefit. The rationale for this exclusion is that the balance involvement passed to the beneficiaries when the grantor created the trust. Thus, the actual transfer of the property at the GRAT's termination is a nonevent for transfer revenue enhancement purposes. If the family business organization can generate a return in excess of the rate used to value the retained annuity payments (120% of the federal midterm rate), the excess will pass to the junior family fellow member free of estate and gift taxation. Upon termination of the GRAT, the property is entirely vested in the beneficiaries; the grantor no longer holds any rights to it. If the senior family member dies before the annuity term expires, his or her taxable manor will include all or a portion of the trust property. Inclusion in the estate obviously is not the intended effect, but the senior member is no worse off than if he or she had not used the GRAT strategy. Because the senior receives credit on the estate revenue enhancement return for the souvenir revenue enhancement already paid (unless death occurs in 2010 and current EGTRRA provisions remain intact), the merely cost is the time value of money on the lost use of any gift tax paid. | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
How much of the trust is included in the senior member'southward manor is an unsettled issue. Revenue ruling 82-105 (1982-one CB 133) indicates that under IRC section 2036(a)(i) the amount to include is the corpus necessary to produce the retained annuity. In letter rulings 9345035 and 9451056, the IRS contends that under section 2039 the entire trust corpus should exist part of the estate. Including whatever amount, however, will undermine the primary objective of excluding the trust property from the senior member's estate. To deal with this event, CPAs should suggest clients to select an annuity term the senior family member is likely to survive. The shorter term volition enhance the family unit's chances of realizing the estate tax benefits of the GRAT and won't necessarily increase the value of the gift.
QUANTIFY THE FINANCIAL IMPACT For clients to truly appreciate the impact these strategies can have on their finances, CPAs need to provide them with a written quantitative analysis of the benefits. Exhibit iii, above, uses proprietary software to compare the financial touch on of the iv strategies for the hypothetical client state of affairs described in the exhibit. It also includes a fifth, "do-aught" strategy (that is, pay the transfer taxes at death) for comparative purposes. Clearly, any of the 4 strategies discussed in this article benefits the family transfer described in exhibit 3. With the numbers to back upward the verbal comparisons of the strategies, almost families volition be motivated to outset succession planning of some kind to lessen the transfer tax impact. FAMILY PLANNING Manor planning, including planning for the transfer of the family business concern, would be a expressionless upshot if Congress had opted for immediate repeal of the estate tax. The delayed implementation of the estate tax changes, combined with the unlikelihood of its ever existence repealed, nonetheless, keeps succession planning in the marketing strategies of CPAs trying to find ways to add together value to their client relationships. Family business owners unremarkably look to their CPAs for revenue enhancement-efficient ways to transfer their businesses to the adjacent generation. Practitioners can use the four strategies discussed in this commodity as a foundation for providing these services. | ||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Installment auction. Source: https://www.journalofaccountancy.com/issues/2002/mar/preservingthefamilylegacy.html
0 Response to "How to Structure an Installment Sale With Family"
Post a Comment