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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 14, 2012
Last week I wrote about Parent & Son, Inc., a business valued at $65 million, and how the business could transfer from Parent to Son at Parent’s death while achieving important objectives and benefits.
That post brought forth another situation, this being one in which the parties want to transfer the business soon rather than after a death, and to use a major asset of the business to provide retirement income for the transferring parent.
Let’s call this one "Father & Daughter, Inc.", an "S" corporation. Father & Daughter, Inc., is a media business valued at $20 million, including all of its assets. Both Father and Daughter are active in the business, but Father is the sole owner. Father wants to transfer his stock in the near future to Daughter and then retire. Father & Daughter, Inc., operates from a building which it owns and which is now worth $5 million, but which has a very low tax basis ($1,000.00). Father would like to take ownership of the building himself, and then to lease the building to the company to provide part of Father’s retirement income. For the other part of his retirement income, Father would like to be paid for his stock. Daughter does not have the money for an all-cash purchase of Father’s stock. Father’s tax basis in the stock is zero, but Daughter nevertheless wants to have a stepped-up basis in the stock when she acquires it. They don’t want to face tax issues over any intra-family transactions for less than fair market value.
Their question: Is there a way to accomplish all of their business, financial and tax objectives?
As with the situation last week, our answer is yes, and here is a way to do so. (I’m sorry about the amount of detail here, but I include it because it illustrates, once again, the flexibility and power of "collateralized installment sale" or "C453" transactions.)
The Real Estate
S.Crow Collateral Corp. ("S.Crow") purchases the building from Father & Daughter, Inc., for $1,000 in cash.
Achievement #1. Because that price is equal to Father & Daughter, Inc.,’s tax basis for the building, Father & Daughter, Inc., has no taxable gain on the sale.
Father and a friend form a new limited liability company (let’s call it "Father & Friend, LLC") in which Friend, an unrelated party for purposes of the tax code, owns at least 50%. S.Crow sells the building to Father & Friend, LLC, for $5 million in cash. (I’ll describe a source for the cash shortly.)
Achievement #2: Because Father & Friend, LLC, is not owned more than 50% by Father, it is eligible for a stepped-up tax basis in the building for both depreciation and to minimize the taxable gain on any later disposition of the building.
Father & Friend, LLC, lease the building to Father & Daughter, Inc., for a lease rent that is equal to its fair market rental value.
Achievement #3: The rent which Father & Friend, LLC, receives is available to provide retirement income to Father and is a deductible expense for Father & Daughter, Inc.
S.Crow buys 79% of Father’s stock immediately on a long-term no-money-down, interest-only C453 contract. After a year, S.Crow buys the other 21% on another C453 contract. Between the two contracts, S.Crow agrees to pay $18.5 million for the stock. (The reasons for that split are beyond the scope of this post.)
Achievement #4: Father defers the tax on the entire gain on sale of the stock, for as long as 30 years or more.
Achievement #5: S.Crow’s installment-interest payments to Father can supplement the latter’s retirement income.
Achievement #6: No annual valuations of the stock are necessary, with their costs and complications.
If the C453 contracts’ remaining term at Father’s death is 30 years, the discount-to-present-value rate is 4%, the marketability discount is 35%, and the estate-tax exemption is $5 million, the two C453 contracts would be valued at $3,807,736 for estate tax purposes in Father’s estate.
Achievement #7: In that event, Father’s estate would incur no estate tax on account of his stock.
Daughter forms a second "S" corporation (let’s call it "Daughter’s New Company, Inc."), of which she is sole owner. S.Crow sells the stock in Father & Daughter, Inc., to Daughter’s New Company, Inc., for $15 million cash. (Again, I’ll describe a source for the cash purchase price shortly.)
Achievement #8: Daughter’s New Company, Inc., now has a stepped-up basis in the stock of Father & Daughter, Inc.
Financing the Purchases
Father & Friend, LLC, borrows $5 million for a short term from a lender of its choosing ("Community Bank") and uses that money to buy the building from S.Crow. S.Crow then introduces Father & Friend, LLC, to a lender which is willing, simultaneously with the closing of the purchase of the building, to lend to Father & Friend, LLC, another $5 million, but on an extended term of 30 years or more. Father & Friend, LLC, uses that money to re-pay the short-term loan from Community Bank.
Daughter’s New Company, Inc., similarly borrows $15 million for a short term from Community Bank and uses that money to buy the stock in Father & Daughter, Inc., from S.Crow. S.Crow then introduces Daughter’s New Company, Inc., to a lender which is willing, simultaneously with the closing of the purchase of the stock, to lend to Daughter’s New Company, Inc., another $15 million, but on an extended term of 30 years or more. Daughter’s New Company, Inc., uses that money to re-pay the short-term loan from Community Bank.
For both loans, the long-term lender is willing to agree that it will not compel the debtor (Father & Friend, LLC, or Daughter’s New Company, Inc.) to pay any money in repayment of loan to the extent, if any, that S.Crow fails to pay its required monthly interest and final principal payments on its installment contracts with Father.
Achievement #9: Both Father & Friend, LLC, and Daughter’s New Company, LLC, have financed their purchases of the building and stock, respectively, with independent (not intra-family) but nevertheless limited-recourse financing and are assured that they won’t have to pay their loans to the extent, if any, that S.Crow doesn’t pay Father as agreed.
Life Insurance for Final Debt Payments
If desired, the long-term lender may require Father & Friend, LLC, and Daughter’s New Company, LLC, to maintain life insurance on Father’s life, and to use the proceeds thereof to pay each one’s loan in full upon Father’s death.
Achievement #10: The loans are cleared on Father’s death, with no further financing cost after that. In the meantime, the policies’ premium cost is a deductible expense for Father & Friend, LLC, and Daughter’s New Company, LLC.
In the years between the closings of the transactions and Father’s death, he may give cash gifts to Daughter as he may choose, without risking a tax dispute about the amount of the gifts.
Achievement #11. Simplicity and certainty accompany any cash gifts. (Ah, something is simple!)
Note A: These transactions do not eliminate Father’s eventual capital-gains tax on sale of the stock. 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 such transaction should be undertaken only upon careful legal, tax and life-insurance advice. (S.Crow does not provide this advice or any other.)
Note C: The numbers stated above do not take into account transaction costs.
Note D: Father’s and Daughter’s stated objectives set a high bar, but we met the challenge.
Note E: This post has already gone on too long for me to deal here with the "economic substance" tax doctrine in regard to these transactions. I’ll just say that it’s clear to me that these transactions are full of economic substance, for reasons such as that real money is borrowed so that real money can be paid for real purchases of the building and stock at their true values, and Father incurs a real tax obligation for his gain in his C453 sale of stock, albeit deferred for a long time and thereby minimized.—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.