Selling the Family Business to ChildrenBeau Ruff
Parents that have built a successful business and have raised capable children might find the proposition of selling the family business to the children compelling. As with so many decisions in life, this proposition comes with pros and cons, but properly structuring the transaction is always vital.
At the outset, the parents must take a hard look at the business and the real prospect of a qualified heir apparent 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 satisfied that their brood includes the right person to take control of the company and allow it to prosper, then the transition strategy can be developed.
The concept of selling the business to children is distinctly different from selling to third parties. Parents are often encouraged to explore favorable sale terms for non-monetary reasons (e.g., keeping business in the family, helping the child or children, as a sort-of payback for effort expended by the child to date, etc.). In other words, a parent is often trying to establish a sale that makes the purchase easy for the child while also providing a respectable (albeit sometimes well below “fair market value”) sale price to the parents. Oftentimes, the sale of the business is also used to create the liquidity to fund inheritance to other children that are not involved in the business purchase.
Gift Rules Apply
A business can be gifted, but how does one determine if any part of the business transition is a gift? Any time a person sells an asset (including the family business) below fair market value to a child, the seller must analyze the application of gifting rules (and the associated gift tax). Gifting applies to the total sale price but could also apply to other parts of the transaction such as the interest rate charged on an installment sale note (where the parents effectively loan a portion of the purchase price to the child buyer). What is a reasonable sale price? The responsible solution is to get the business appraised by a qualified business valuation expert. This allows a competent third party to evaluate business 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.
Whether the interest rate charged by the seller parent to the buyer child is a gift is more straightforward. The IRS monthly publishes the Applicable Federal Rate (AFR) which is used to determine if the interest rate charged gets into gift territory. The long term (over 9 years) AFR for May of 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 gifting rules.
Favorable Timeline and Interest Rates
Parents often structure these sales with the minimum amount of down payment, carry the loan for a period longer than a typical third-party sale, and charge lower interest on the contract balance. For example, a parent trying to avoid the implication of gifting (but still create favorable terms for the child) might require no down payment, a ten-year installment plan, and 2.66% interest on the declining balance (based on the May 2022 AFR).
Stay Vigilant to Protect from Creditors
Though parents want to make the transaction simple for the child, parents should remain vigilant to protect their own interest from creditors. If parents structured the transaction as an installment plan, the parents would be wise to maintain a security interest (collateral) in the property sold. The seller can maintain a security interest in the company stock, the accounts receivable, the inventory, the assets, and virtually anything else owned by the company. Why would parents want to do this if they trust the child to make payment? Taking a security interest ensures that the parents have the first right to the asset secured in the event of other creditors making a claim. So, if the business does fail in the hands of the next generation and the company moves into bankruptcy, the parents’ wise decision to demand collateral could ultimately protect some or much of the value of the company from creditors that might otherwise be entitled to it and preserve the business in the family.
A common misunderstanding regards the limits of gifting. The federal gift annual exclusion allows parents to make gifts of up to $16,000 without any reporting requirements, but parents can gift much more than that. For example, under current law, a couple can gift a total of $22.12 million during their lifetimes before being required to pay any gift tax, but that couple would be required to file a federal gift tax return. And, if a couple made a gift that large, it would entirely eliminate their estate tax credit thus pushing all assets remaining to the 40% tax level at death. Accordingly, a gift that large should be heavily scrutinized.
More likely, the parents might choose to gift, 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 to finance the remaining $4 million purchase price. This too would require filing a gift tax return, but no gift tax would be owed.
The opinions voiced in this material are for general information only and not intended to provide specific advice or recommendations for any individual or entity. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor.
Securities offered through LPL Financial, member FINRA/SIPC. Investment advice offered through Cornerstone Wealth Strategies, Inc., a registered investment advisor and separate entity from LPL Financial.