By Beau Ruff

Let’s assume that the patriarch of a local manufacturing business is ready to determine the best way to transition ownership of the business to his daughter.

Beau Ruff,

The patriarch, John, and his wife, Jane, are ready to hand over the reins and move into retirement. Still, the future success of the business is extremely important to the family and the parents want to make sure it succeeds. Though all three of their kids have worked in the business to some degree, the parents recognize that their eldest child of three, Kate, has worked the most and the hardest, and really contributed to the success of the business. At the same time, the parents want to reward Kate for her contributions to the business, the parents also want to somehow provide for the other two children as well.

Simply gifting the business doesn’t work best.

There are several constraints that impede the parents’ ability to freely transfer the business or its assets. These constraints fall broadly under the idea of gifting. Any gift of value greater than $14,000 is a reportable gift. This means that the parents would need to file a gift tax return and the amount of the gift would be subtracted from the parents’ federal Unified Credit. This gift could also expose the parents to the imposition of a gift tax.

A “gift” can come in a variety of forms. But, in this transaction it could take the appearance of a simple gift (giving the assets or stock of the company to Kate) or a sale for less than fair market value (allowing Kate to buy the company at a sweetheart deal). There can even be a “gift” where the parents sell to Kate at a price equal to the fair market value of the business and allow her to pay over a term of years if the interest rate is too low. Indeed, the IRS publishes monthly the list of the Applicable Federal Rate which translates to the lowest allowable interest rate without incurring “gift” considerations.

All of these scenarios are “gifts” under federal law. Plus, if the parents simply gift the asset, then the other children could be deprived of their inheritance which conflicts with the parents’ goals.

Drawbacks of straightforward sale

A sale of the business to Kate at fair market value would accomplish several of the parents’ goals. It would move the business to Kate’s ownership. It would ensure other resources are available for the other children to inherit (the cash received from the sale). The gifting impediments wouldn’t apply. The problem for Kate, however, is twofold. First, she needs to come up with a sufficient down payment and installment payments to meet the terms of the sale. This could be a difficult proposition for Kate. Second, to make the payments, she needs to first take the earnings out of the business and subject those earnings to tax. Then, she would use the after-tax proceeds to make the payments to her parents for the sale of the business. Plus, the straightforward sale does nothing to compensate Kate for her work in the business and her assistance in growing the business.

Combining best of gifting, best of selling

Suppose we combine the best aspects of the two approaches above. The parents decide to gift some amount of the business to Kate for two reasons. First, it recognizes that the value of the company was due, in part, to her efforts. Second, it gives Kate a better possibility of making the required installment payments for the company. For discussion purposes, let’s say the parents gift 10 percent of their stock of the business to Kate. This gift could have the added benefit of substantially reducing the parents’ estate tax exposure (explored in other columns by this author). But, it also vests Kate with ownership to allow the second part of the transaction to occur: the redemption. Different from sale, a redemption is when the company itself buys back shares. So, instead of Kate directly buying the shares from her parents, she (as president) directs the company to buy her parents’ shares (of course with their understanding and agreement beforehand) with an installment contract. At the conclusion of the redemption, even though Kate only initially owned 10 percent, by virtue of being the last remaining shareholder, she is then vested with 100 percent ownership of the company. Though the company will need to use after-tax dollars to fund the purchase (redemption) of parents’ stock, the interest payments on the obligation are deductible by the company. Kate’s siblings are provided a cash inheritance provided by Kate’s cash payments for the company.

The small print

It is important for the redemption strategy to work and the sale to be treated as a sale (exchange and not a disguised “dividend” in IRS speak), the parents can have no further interest in the business except as a creditor collecting the payout amounts (Internal Revenue Code, section 302). It is noteworthy that this is one select strategy of many available and alternate strategies may work better. And, as always, be sure to consult a qualified attorney and tax professional to discuss your specific circumstances.

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Attorney Beau Ruff works for Cornerstone Wealth Strategies, a full-service independent investment management and financial planning firm in Kennewick, where he focuses on assisting clients with comprehensive planning.