When business owners consider ways to sell their business to family members, the tax implications associated with the various choices are a key consideration in their decision-making process. Several options exist. Among them are:
Grantor Retained Annuity Trusts (GRAT) – With this arrangement, a business owner can pass the business on to a family member by placing the stock of his or her business into an irrevocable trust that will pay him or her an annuity equal to the value of the property over the term of the trust, plus the Internal Revenue Service interest assumption over a fixed period of time.
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At the end of the fixed time period, the stock is distributed to the family member and is no longer considered part of the parent’s estate.
If, at the end of the fixed-time period, the stock has appreciated by more than the IRS-assumed interest rate, the profits pass on to the family member tax free. However, if the business owner dies before the end of the fixed time period, the stock would be taxed as part of his or her estate.
Companies use the GRAT as a succession tool when they believe that the company will appreciate by more than the IRS-assumed interest rate, currently approximately 7 percent, said Bruce J. Bettigole, a Providence lawyer who works with estate plans. For example, if a business owner believes his company’s value will appreciate by 20 percent over the next four years, he will use the GRAT to transfer the business to his children without having to pay taxes on the appreciation, he said.
”A GRAT is successful when you have rapidly appreciating assets,” Bettigole said. “It’s used when you think you can beat the (IRS) tables,” he said, referring to the IRS assumed rate of growth. But if the company is not growing rapidly, this may not be the best succession option, he added. “If that stock is not growing faster than the IRS interest assumptions, that’s not an effective planning tool,” he said.
Installment Sales – In this type of transaction, the children of the business owner buy the stock of the company and pay for it over a given period of time. This is beneficial because the buyers, the children, can benefit from the stock’s appreciation. The deal should be structured so that the cash flow from the business is sufficient to amortize the note and still allow the business to function, Bettigole said.
Buy-Sell Agreements are commonly used planning tools. In this agreement, two business partners, the two shareholders of the company, agree to buy each other out – or at least have the first option to buy the other out – should one of the partners die, become disabled, or leave the company. Usually, the buyer obtains the money to buy the other shareholder out through an insurance policy, either life insurance or disability insurance. If the shareholder decides to leave the business, she or he would sell her or his stock in the company to the other shareholder at a pre-determined price.
Another way to fund a buy-sell agreement is through a private reserve fund. The transaction can also be set up so that the buyer pays for the stock in installments. The note would carry a fixed interest rate and would be secured by the shares that are being sold.
The difficulty with buy-sell agreements when they are used between family members is that the IRS will scrutinize such deals to make sure they are not really disguised gifts or bequests. To avoid any such problems, Bettigole recommends that the shareholders have their business appraised. This way, it can be proved that the buyout price is equal to the appraised value of the company, he said.
Private Annuities are a succession tool that experts say is talked about often, but seldom used. Here is how it works: A business owner sells his company to his children in exchange for fixed annuity payments that last the rest of the business owner’s life. But if the seller dies before he is expected to die – that is, before the age at which the IRS actuarial table says he should die – the children end up paying less for the company than it is worth.
The other side of that, however, is that if the seller lives longer than the actuarial table age, he will continue to receive payments, and the children will pay more for the company than it is worth.
“Effectively, the children are betting (that) the parent is going to die early,” said Benjamin G. Paster, a Providence lawyer. “If the parent lives too long, the children are overpaying. It does have the advantage that payments stop at death – if he (the seller) died prematurely, the children have received a windfall.”
