In a perfect world, creating and implementing your estate plan would be a straightforward process. Your intended distribution of assets would meet your goals and your family would see the plan as equitable to everyone.
In reality, however, developing an effective estate plan can be a challenge both emotionally and financially. For example, you may own an illiquid asset that comprises a large part of your estate, such as a closely held business or income-producing real estate. You would like to make gifts of the asset to your children, but any of the following circumstances could restrain a gifting program:
- You depend on income from the asset
- You believe large gifts have a negative impact on recipients
- You want to make a major gift of the asset to one child but want to avoid family disputes and you lack sufficient liquid resources to equalize distributions
Selling the asset outright to one or more of your children— assuming they have sufficient capital— would help you avoid these constraints. But, if the children lack the resources for an outright purchase, an intrafamily sale could be the solution. Intrafamily asset sales may help you facilitate the asset’s transfer and also help you achieve multiple financial and estate planning objectives.
Based on your individual circumstances and goals, there are a wide variety of methods you can employ when structuring an intrafamily sale, with potential short- and long-term benefits for you and your heirs.
If you sell the asset to a family member for less than its fair market value, that constitutes a bargain sale. From a tax perspective, if you sell for less than the property’s fair market value, the difference between the value and your selling price is treated as a gift. For instance, assume that your business has a cost basis of $250,000, and a fair market value of $1 million. You sell the business to your daughter for $500,000. The result: a taxable gain to you of $250,000 (the sale price, minus your basis) and a gift of $500,000 to your daughter (fair market value, minus the sale price).
The primary benefit from this transaction— and intrafamily sales in general— is that the sale removes the business’s future appreciation from your estate. The income tax impact will depend on the payment schedule. If you receive a one-time payment, your entire profit is taxed in one year. But, if you take back a note that provides for a series of payments, you will be able to use the installment method and pay the tax on the gain as you receive the payments.
Installment sales are structured so that you receive at least one payment after the tax year in which you sold the property. This method allows you to spread the taxable gain over time and defer a portion of the tax liability on any profits. For example, assume that your business has a cost basis of $250,000, and a fair market value of $1 million. You sell the business to your son for $1 million, which generates a taxable profit to you of $750,000 (the sale price, minus your basis). The sales agreement requires him to make ten annual payments of $123,338 to you, based on an assumed 5 percent interest rate for the note.* In contrast to a one-time payment that generates an immediate tax liability, each installment payment you receive will be treated as consisting of return of capital, gain, and interest income. In this example, the amounts will be:
Return of capital: $25,000
Taxable gain: $75,000
Taxable interest income: $23,338
Some sales, including inventory and depreciable assets, are ineligible for the installment sales method. There are also tax implications if a related buyer resells the asset within two years of the transaction. Assuming that you can avoid these restrictions, an installment sale can make the transaction more affordable for the buyer and it allows you to defer income taxes. If you plan to retire after selling the business, the payments can provide a supplement to your retirement income. In addition, your potential estate taxes are reduced because only the note’s value is included in your estate and any post-sale appreciation in the asset’s value accrues to the purchaser.
Self-Canceling Installment Notes (SCIN)
The previous example assumed that your son would continue to make the scheduled payments to your estate if you died. A SCIN also has a fixed number of payments, but the outstanding balance is forgiven if you die before receiving all payments. The value of the future payments is not included in your estate because the repayment obligation ends with your death. However, any deferred gain that remains outstanding is triggered at your death and will be taxed to your estate.
There is a cost for the debt-forgiveness feature. A note that is canceled on your death before all payments are made is worth less than a note that must be paid for a fixed term. To avoid having the IRS consider the note a partially taxable gift from you to your son as the buyer, the SCIN must include a risk premium to reflect the risk that you may die prematurely. That premium consists of a higher interest rate than would be charged on a traditional installment sale note. The higher rate results in a larger payment from your son and greater interest income to you.
Traditional installment sales and SCINs have fixed repayment terms, although a SCIN self-cancels at your death. In contrast, private annuities require payments for the remainder of your life, no matter how long you live. You can also structure the arrangement as a joint and survivor annuity— with your spouse, for example— so that the payments will continue until the death of the second survivor. The payments end at the final recipient’s death, so there are no remaining payments to include in your survivor’s estate.
If the annuity’s value equals the fair market value of the transferred property, there is no gift in the transaction, and the private annuity’s payments will be based on your life expectancy and prevailing interest rates as determined by the IRS. As with a SCIN, each payment you receive consists of cost recovery, gain, and income. The transferred asset’s future appreciation is removed from your estate, and in contrast to a SCIN, your death will not trigger any taxes on the remaining gains.
Sales to Irrevocable Defective Grantor Trusts (IDGT)
An IDGT is considered a grantor trust for income tax purposes, which means that you— as the trust’s grantor— report the trust’s income and pay taxes on that income. In addition, transactions between you as grantor and the trust are ignored for tax purposes, which means that you can sell appreciating assets to an IDGT in exchange for a note without triggering gain on the sale. The sale removes the assets’ appreciation from your estate, and because the trust is irrevocable, only the note’s value will be included in your estate. IDGTs may be subject to challenges from the IRS, so you should consult with your tax and legal advisors before establishing one.
Intrafamily sales are complex transactions and this brief introduction only touches on their potential applications for transferring valuable assets. Each of these methods has strengths and weaknesses in terms of suitability, complexity, and cost, and your goals will determine which techniques are most appropriate. When structured correctly, intrafamily sales may help you reduce gift and estate tax obligations while you pass valuable assets to your heirs.
* The applicable federal rates used in these transactions vary; speak with your advisor for more information.