United States business ownership is
starting a dramatic and long-term
transition. The amount of owners who will try to sell their businesses will
grow 500 percent from 2007 to 2011,
according to one study; another found that
40 percent of CEOs of family-owned businesses expect to retire in the next five
years. It’s clear that family businesses will
soon pass from one generation to the next.
But will outgoing owners also pass down
a large tax bill and debt burden with the
sale? Not necessarily, depending on how
the transaction is structured. There are
four strategies commonly used to transfer
the family business: Installment Sale to a
Defective Grantor Trust (see our Article in
Smart Business, March 2007), Self-canceling Installment Note (SCIN), Private
Annuity, and Grantor Retained Annuity
Trust (GRAT).
Self-canceling installment notes, or
SCINs, provide a way to transfer a family
business that can protect the buyer from
burdensome payment schedules and protect the seller from estate taxes.
In Part 1 of a two-part series, Smart
Business spoke with Rick Appel of
Advanced Strategies Group to learn more
about how to use SCINs and structure
them for maximum advantage.
What is a SCIN?
A self-canceling installment note is a
structured payment plan with special provisions if the seller dies. SCINs are used to
transfer family businesses from one generation to the next. The seller (who is
referred to as the senior family member)
sells the business to the junior family member (buyer), who agrees to make regular
payments until the full price is paid or the
seller dies, whichever comes first. The
transaction is considered a contingent sale
because it is based on the contingency that
the seller will die before the note matures.
There are some legal restrictions on the
terms of a SCIN. An IRS regulation states
the period specified for the junior family
member to make payments must be less
than the senior family member’s life expectancy. Otherwise the transaction
may be treated as a private annuity.
How is life expectancy determined?
The IRS has life expectancy tables.
However, in situations where death may be
imminent, the tables don’t apply and the
IRS makes a judgment as to the reasonableness of the deal and the appropriate
taxation. The IRS judgment takes into consideration the seller’s health, length of the
payment contract and the down payment
amount. If the payment schedule is longer
than the seller’s life expectancy, the IRS
treats the transaction as a private annuity.
Can the seller use a SCIN to give the buyer a
‘sweetheart deal’ or ‘family discount’ on the
sale?
There are IRS requirements in place to
prevent that. If the value of the self-canceling note that the seller receives from the
junior family member is less than the fair
market value of the business, the difference is considered a taxable gift and subject to the gift tax. The gift tax can be easily avoided by valuing the business fairly
and structuring the payment terms accordingly. The IRS will take the seller’s health into consideration when determining the
reasonableness of the transaction.
What are the income tax consequences of a
SCIN?
For qualified SCINs, the seller reports
income from the sale as a gain, which is
calculated as the maximum sales price. It
assumes the transaction will be paid in full
before the seller dies. The seller’s reported
gain includes return of basis, capital gain
and interest income. If the seller dies
before all payments are received, the gains
are accelerated and reported as income for
the deceased’s estate tax. The buyer can
deduct interest from SCIN payments from
his or her personal income tax. Various
events can also trigger a stepped-up basis
for the buyer.
How else do SCINs impact estate tax?
Remember, the ‘SC’ in SCIN stands for
‘self-canceling.’ The debt can be canceled
by the seller’s death. SCINs can be structured so the value of the canceled payment
obligation is not counted as part of the
estate for estate tax purposes. This exclusion is available if the buyer paid an adequate premium. However, any SCIN payments that were received but not spent
before the seller died are a taxable part of
the estate. In short, income from past payments is taxable, future payment obligations don’t have to be.
Watch for Part 2 next month with information on the new rules for the Private
Annuity as well as information on
Grantor Retained Annuity Trusts
(GRATs).
RICK APPEL is a CPA and senior vice president at The
Advanced Strategies Group, which specializes in wealth preservation and transfer. Reach him at (248) 359-2480 or
[email protected].