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.
In that case the non-compete agreement was for 3 years and the court found that the employer failed to show that the term was reasonable even though the employer asserted that the employee was a former shareholder of the employer which granted him access to trade secrets and strategic plans. Prime Group, Inc. v. Donald Dixon (W.D. Wash. 2021). To exceed 18 months, the law requires that the employer prove “by clear and convincing evidence that a duration longer than eighteen months is necessary to protect the party’s business or goodwill.” RCW 49.62.020. That proof standard of “clear and convincing” evidence is an elevated burden of proof. This means both that the burden of proof is on the employer (and not the employee) and that the employer has a heightened level of proof.
As a final note, the new law has not entirely replaced the reasonable analysis that was the hallmark of pre-2019 non-compete enforcement analysis, instead, it created another level of scrutiny. Therefore, the non-compete agreement need not only comply with the 2019 law, but must also still meet the reasonableness tests from Perry v. Moran, 748 P.2d 224 (Wash. 1987) that courts look to in order to determine enforceability: “(1) whether restraint is necessary for the protection of the business or goodwill of the employer, (2) whether it imposes upon the employee any greater restraint than is reasonably necessary to secure the employer’s business or goodwill, and (3) whether the degree of injury to the public is such loss of the service and skill of the employee as to warrant nonenforcement of the covenant.”
Taken together, the enforcement of a non-compete agreement looks to require an excellent set of facts and a skilled attorney to draft the agreement.
* Licensed, not practicing.
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.
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