When Should I Sell a Piece of My Company to a Non-Grantor Trust?
From Your Multimillion-Dollar Exit, by Wayne Zell
Q: What is an installment sale of a company and how does it work?
A: In an installment sale, you could sell part or all your business interest to a trust for the benefit of your spouse and family for a promissory note that bears interest only, with the principal amount becoming due at a specified maturity date. Depending upon the duration of the note, the IRS's applicable federal rate would determine the interest rate. While the note may or may not be secured, it must be enforceable under local laws.
Q: What is an example of an installment sale for a business?
A: One example is selling an appreciated business interest to either children or heirs directly, or to a non-grantor trust established for the benefit of children or heirs, through a taxable installment sale.
Q: What's the advantage of selling to a non-grantor trust?
A: One advantage of selling to a non-grantor trust is that it allows you to lock in the capital gains at a fixed value while deferring the recognition of the gain until payments are made under the promissory note. This strategy can effectively transfer the appreciation in value to the trust beneficiaries.
Q: How is the taxation handled for interest and principal payments received from the buyer?
A: Interest received from the buyer is taxable at ordinary income tax rates. On the other hand, principal payments are subject to taxation as long-term capital gains and return of capital, but only when the principal payments are actually received.
Q: What is the difference between using a grantor vs a non-grantor trust?
If you sell the business interest to a grantor trust (the income of the trust is taxable to you as the grantor), the sale is ignored for income tax purposes. In other words, the trust doesn’t pay income tax; you do, so you are treated as if you are selling the interest to yourself.
If you sell the business interest to a Non-Grantor trust (which is treated as a separate taxpayer) the note usually will allow you to defer income tax until installment of interest and principal payments are received.
One major exception to this rule is when the buyer is related to the seller and sells the assets within two years of the original purchase. In that case, the gain in the original sale would be accelerated.
Q: How does this technique work in terms of estate planning and potential tax benefits?
A: This technique is beneficial for removing any future appreciation of the asset from your estate upon your death. However, it's important to note that the present value of the promissory note is included in your estate if you pass away before the note is fully repaid. The attractiveness of this technique can be influenced by changing interest rates – as interest rates rise, its benefits may decrease.
Q: Are there any conditions for the buyer if they are related to the seller?
A: Yes, if the buyer has a familial relationship with the seller (such as being their children or a non-grantor trust for their benefit), the buyer must hold onto the purchased asset for a minimum of 2 years for the seller to qualify for installment sale treatment.
Q: Is there a limitation on the size of the installment sale to avoid interest charges on deferred taxes?
A: To avoid interest charges on deferred taxes, the total amount of the installment sale should be less than $5 million per taxable year. If the taxpayers are married filing jointly, the limit increases to $10 million in any given taxable year.
Example: Ideas in Action
Let’s say Randi owns a business worth $5 million (with an income tax basis of $0) and wants to sell 20% of the business ($1 million before discounts) to a non-grantor trust for her kids in return for a promissory note.
Assume the purchase price (the promissory note) can be discounted by 30% because she is selling a minority interest that lacks marketability. This means the principal amount of the note is worth $700,000 ($1 million x (1-30%)). Also, assume the note is payable, interest only, for 10 years when the entire note is due.
If Randi and the trust sell the business 3 years later for $10 million cash, the trust will receive $2 million cash and have a gain of $1.3 million ($2 million - $700,000 purchase price), taxable at long-term capital gains tax rates.
Meanwhile, Randi will continue to pay ordinary income tax on the note interest payments as they are made and will defer long-term capital gains tax on the original $700,000 note payment until payment is made in year 10.
If you are thinking of selling a piece of your company to a non-grantor trust, contact Zell Law today.