Small business owners face many challenges when determining how to best transfer assets to their children. In some cases selling the business might not make sense if the family wants to retain the asset.
Due to the illiquidity associated with a closely held business a thoughtful strategy must be developed to transfer all, or a portion of the asset, out of the owner’s name to minimize potential estate taxes.
When selecting the appropriate strategy, there are many questions to be considered to determine which transfer technique is most suitable. Some of the most important ones are:
The owner of the business or asset sells to another individual but receives the payment in a number of installments over a number of years. This allows the owner to spread out the taxable gain and defer paying taxes on the sale of the property or business over the terms of the installment payments. The seller creates cash flow and removes an appreciating asset & future installment payments from their estate. It also allows the buyer additional time to secure funding for the purchase which may increase the sale price.
Disadvantages – If the seller dies before the end of the terms the remaining present value of the note is included in the seller’s estate. If the seller’s will forgives the reaming debt, it is considered paid to the estate and the seller’s estate reports the remaining gain.
A type of installment sale was after the seller’s death the remaining payments are canceled and not included in the seller’s estate. The buyer pays a premium for the asset in exchange to the self-canceling possibility. The remaining payments would appear on the seller’s final income tax. This is appropriate for ultra-high-net-worth individuals who have a 40% estate tax.
The owner sells a business asset and the buyer leases it back to the company. This allows the business owner to continue using the asset while deducting the lease payments as a business expense. Additionally, the asset is removed from the seller’s estate.
The owner gifts a fully depreciated business asset to a child or family member who is in a lower tax bracket. The asset is then leased back to the company. This allows the business owner to continue using the asset and also deducted the lease payments as a business expense. The asset and the income stream of the lease are removed from the business owner’s estate.
Using the annual gift tax exclusion shares of an S Corp are transferred to younger family members. The income associated with the shares is shifted to the receiving family member, and the shares are removed from the original owner’s estate. It is important to have
a certified valuation done to determine the percentage being gifted each year based on a valuation formula. It is also critical to be aware of the kiddie tax rules if the recipient is under the age of 24.
FLPs are a structure used to transfer the interests of illiquid family investments or businesses. Due to the nature of their illiquidity, the IRS allows the asset to be substantially discounted during the transfer. The transferee of the FLP interest can claim a “lack of control” discount, as the general partner controls the management of the business. The limited partners are unable to sell their interests, thus the transferee also receives a “lack of marketability” discount. As a result, these discounts allow for a larger percentage of the partnership’s interest to be passed using the annual gift exclusion. A third-party appraisal is a good idea if not essential when claiming a discount.
Disadvantages– The transfer of interest is passed with the original basis and does not get a step-up at the time of death. The general partner has unlimited business liability for claims on the business.
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