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176. Does an Installment Sale Defer the Tax on Recapture of Accelerated Depreciation? No. Can the Tax on Recapture of Accelerated Depreciation Nevertheless Be Deferred When an Installment Sale Occurs? Yes.
162. Transfer a Family Business to the Next Generation During the Parent's Lifetime, Retain an Asset for Income, Give the Transferee a Stepped-up Basis, Defer the Gain on Sale, Support the Parent with Deductible Rent, and Finance the Transaction, Too
November 6, 2012
Parent & Son, Inc., is now valued at $65 million. The business was built by Parent and is entirely owned by Parent. Parent is its chief executive officer, but Parent is becoming less and less necessary to the successful operation of the business. Parent expects to remain active in the business until his death, when he wants the business to pass to Son, if Son (who is Parent’s only heir) wants to have it. Son likes that, but Son has other interests as well, and so may decide to sell the business to someone else after Parent’s death. Parent is in good health and is insurable.
Parent’s objectives: (1) Eliminate the estate tax on transfer to Son; (2) enable Son to acquire the business without going into debt to do so and without being forced to sell part or all of the business to anyone else; (3) avoid the cost and complications of annual valuations of the company stock that a program of gifting stock to Son could entail; and (4) if Son decides to sell the business, minimize the tax cost on doing so.
Parent’s question to S.Crow Collateral Corp. ("S.Crow") is this: Could a collateralized installment sale ("C453") transaction accomplish these objectives?
Our answer is yes, and here’s how.
Parent contracts now with S.Crow to sell the business to S.Crow on Parent’s death, on a long-term installment contract with monthly interest payments beginning then. The contract goes into force now and becomes binding now, but the sale doesn’t close until after Parent’s death; Parent remains its owner and operator until then.
The price is set at today’s value of $65 million, so the contract effectively "freezes" the value of the business at that amount, even though the business will presumably be worth much more than that when Parent’s death occurs. If the contract is interest-only throughout its term, if its term is 55 years, and if the discount-to-present-value rate is 4%, the contract upon Parent’s death would be valued at $7,517,608. A 35% marketability discount would further reduce that to $4,886,445. If the estate-tax exemption is $5 million at the time, Parent’s estate would incur no estate tax on account of the business.
Achievement #1: That eliminates both the estate tax and the annual-valuation complexities of a gifting-of-stock program, which is made unnecessary.
To arrange for Son to acquire the business, S.Crow simultaneously enters into a contract to sell the business to Son, effective upon S.Crow’s acquisition of the business and at a modest mark-up. Son agrees to pay that amount to S.Crow in cash, and Son further agrees with S.Crow to fund that arrangement with life insurance on Parent’s life. Parent annually gifts to Son a sufficient amount of money to cover the premium cost, which should be tax-deductible for Son, as a cost incurred by Son to support Son’s debt obligation to S.Crow.
Achievement #2: That enables Son to acquire the business at approximately its value today, and to do so with proceeds of life insurance paid for with tax-deductible dollars.
Upon Son’s purchase of the business from S.Crow, S.Crow introduces the executor of Parent’s estate (who may be Son) to a lender which is willing to lend to the estate an amount that will be approximately equal to the $65 million. S.Crow arranges for its installment-interest payments and final principal payment to cover the estate’s loan-interest and final loan-principal payment obligation. The lender agrees not to compel repayment of the loan in any amount in excess of S.Crow’s payments on the installment contract. So, unconstrained by any need to provide other funds for repayment of the loan, the estate is free to distribute approximately $65 million in cash to Son. (Being loan proceeds, the $65 million doesn’t add any net amount to the taxable estate.)
Achievement #3: Son has a $65 million distribution of cash, and also owns the business free and clear. It’s a have-your-cake-and-eat-it-too situation.
Then, if Son decides to sell the business after a one-year holding period, another C453 transaction can enable Son to defer the tax on the gain above Son’s tax basis (approximately the $65 million). If Son does so, his strong cash position from the $65 million distribution from the estate will position him well to bargain for the best deal when he sells the business—which, by the way, is not encumbered by the $65 million loan to the estate.
Achievement #4: Son is able to maximize value on resale of the business, and to defer all of the tax.
Achievement #5: The business is debt-free, at least as concerns any of these transactions.
Contemporaneously with Son’s C453 resale of the business (to S.Crow and then by S.Crow to the ultimate buyer), the lender extends a new loan to Son in an amount approximately equal to the resale price, again with loan repayment limited to amounts paid to Son by S.Crow on the C453 contract, and with no lien on Son’s other assets or the business which Son is selling.
Achievement #6: Son enjoys liquidity from the non-taxable proceeds of two loans: the approximately $65 million loan to the estate when Son buys the business, and another loan that is nearly equal to the then full value of the business when Son re-sells it. Son is able to pursue his interests, wherever they may take him.
Achievement #7: All of this can be repeated, in turn, for Son’s estate planning.
Note A: While these transactions can eliminate Parent’s estate-tax liability (and can be repeated later for Son), they defer but do not eliminate the capital-gains tax on the sale(s). Nevertheless, when the tax is deferred for a very long term such as 30 or more years, all of the sting is taken out of whatever tax-rate increases may come along in the meantime.
Note B: Any C453 transaction should be undertaken only upon careful legal and tax advice. Any C453 seller—because of the loan proceeds to invest—would benefit from advice about life insurance and other investment products. (S.Crow does not provide this advice or any other.) Life-insurance advice is especially important in the C453 transaction described above for Parent, in which life insurance is used to fund Son’s purchase of the business.—Stan Crow
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The Latest Installment addresses situations, questions and issues which are brought to us in the course of the consideration, negotiation or execution of transactions. We don't use the real names of parties to transactions, and we may edit the statement of the question to try to tell the story better. Please feel free to comment, or to take issue, or to raise your own question or situation. If you do the latter, please do not relate any confidential information.
The Latest Installment blog is edited by Stanley D. Crow, who is president of S.Crow Collateral Corp.