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 RAppel@AdvancedStrategiesGroup.com.