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Introduction

When installment payments are used, the seller funds the buy-sell agreement. Payments of a set principal amount plus interest at a specified rate are promised to the seller over a certain period of time. Sometimes the use of installment payments is the funding method selected when a buy-sell agreement is drafted. Other times, use of the installment method is an option, when cash or third-party borrowings are unavailable at the time of the business sale.

When Can It Be Used?

You Are Willing to Accept Payments Over Time, and You Are Comfortable That the Buyer Will Be Able to Keep Up the Payments

If you feel comfortable that you (or your estate) will not need the sale proceeds in a lump sum, and that the buyer will be able to continue making payments over the installment period, the installment payment funding method might be appropriate for your buy-sell agreement. Installment payments may be particularly appropriate when the corporation is the buyer because it may prevent the corporation from having cash flow problems or may avoid depleting the company's cash reserves.

Tip: If you do not want your estate to help finance the sale of your business interest (or you are not certain), you should make sure another funding method is written into the buy-sell agreement.

Strengths

Can Be Effective Funding Tool for Buy-Sell Agreement with Family Member

Sometimes, the primary objective of a buy-sell agreement in a family-owned business is to ensure that the business remains in the family, with less of an emphasis on the sale price or payment method. When the buyer under your buy-sell agreement is a family member, installment payments can be an important funding method, allowing the business to stay within the family, while minimizing the cash needed at the time of the transfer. In addition, the interest payments remain within the family, instead of being paid out to a bank or third party.

Caution: It might be tempting to set a low interest rate, or none at all, when your buyer is a relative. Be warned, interest must be paid on the unpaid balance. In addition, if the IRS does not deem the interest rate "adequate" it will set a new interest rate for your payments. The IRS's new interest will reflect current market rates at the time the buyout occurs and could be much higher than the market rate in effect at the time the agreement was drafted. If this happens, part of your payment would be treated as interest (based on what the IRS determines), effectively reducing your sale price so that the total paid includes an adequate interest rate.

Can Be Effective Funding Tool with Entity Purchase Buy-Sell Agreement

Installment funding can be very effective when used with an entity purchase buy-sell. Use of this method can prevent the company from having to come up with a big chunk of cash at the time of transfer, which might otherwise have a negative impact on the company's cash flow.

You (Or Your Estate) Receive an Income Stream for the Period of the Payments

When installment payments are used for buy-sell payment funding, you (or your estate) would receive periodic payments of the sale price plus interest over a time frame set forth in the agreement.

Tip: Formalize your installment agreement in writing with a promissory note. If the buyer stops making payments, you can have the court system enforce the note.

You May Be Able to Spread Gain From Lifetime Sale Over Payment Period

If the sale of your business interest occurs during your lifetime, for instance at your retirement, and your business is a cash basis taxpayer, installment payment funding can allow you to spread any capital gain on your sale over the payment period.

Very Simple Method

Installment payments can be a simple process. When the time comes to make the purchase, the buyer begins the payments to the seller. A formal promissory note should be drafted to document the buyer's promise to pay you.

Caution: The financial position of the buyer might have changed adversely between the time the buy-sell is drafted and the time the sale of the business happens. If this happens, you or your estate may not receive timely payments.

Tradeoffs

Buyer Gets the Business; You or Your Estate Might Not Get All the Cash

The buyer takes control of the business at the time of sale. The business is now burdened by the need to make the installment payments, thus lowering the income of the new owner. It is possible that the burden of installment payments might affect the buyer's ability to get outside credit, in turn affecting the ability to expand the business. At the same time, you (or your estate) are tied to the continued financial success of the business and the new buyer.

Your Estate Does Not Receive Immediate Liquid Funds For the Sale of Your Interest--Could Have Trouble Paying Taxes

If installment payments are used when your business interest is sold at your death, your estate will not receive the full purchase price in a lump sum. Estate taxes, however, must be paid in full when the estate tax return is due (usually nine months after death). Installment payment funding could defeat what might have been the major reason you entered into the buy-sell agreement--to provide your estate with liquidity for taxes and expenses.

Long Payment Term for Corporate Buyer Could Jeopardize Your Tax Treatment

If the installment payment period extends for a long period of time (more than 15 years), and the buyer is a corporation, the IRS could view you or your estate as a shareholder instead of a creditor. This view could cause the payments to be treated for taxation as dividends instead of as a sale or exchange. This could mean higher taxes for you as the seller. It could also affect the corporation as the buyer because dividend payments are allowed only under certain conditions.

Note: In general, the American Taxpayer Relief Act of 2012 permanently extended the preferential income tax treatment of qualified dividends and capital gains. Capital gains and qualified dividends are generally taxed at 0% for taxpayers in the 10% and 15% tax brackets, and at 15% for taxpayers in the 25% to 35% tax brackets. However, capital gains are generally taxed at 20% for taxpayers in the 39.6% tax bracket. Also, as a result of the Affordable Care Act of 2010, an additional 3.8% Medicare tax applies to some or all of the net investment income for married filers whose modified adjusted gross income exceeds $250,000 and single filers whose modified adjusted gross income is above $200,000.

However, there remains an advantage in classifying a transaction as a sale or exchange rather than as a dividend distribution despite the fact that both types of transactions are subject to tax at long-term capital gains tax rates. That is, in the case of dividend treatment, part or all of the distribution is first treated as a dividend, any remaining distribution is then received tax-free to the extent of basis, and any distribution still remaining is taxed as capital gains. In the case of sale or exchange treatment, however, the shareholder pays tax only to the extent that the amount paid by the company exceeds his or her basis in the stock. Thus, more may be subject to tax with dividend treatment than with sale or exchange treatment.

How to Do It

Things to Do Now

Think About How Much Risk You Are Willing To Accept

If you are confident that your buyer will be able to make the payments over the full installment period, then using installment payments to fund the purchase may be appropriate for your buy-sell agreement. However, if you would like more certainty that payment for the sale will be both available and accessible, you may want to look at alternative funding methods such as stock redemption, sale-leaseback, or life insurance.

Tip: You might want to set up the buy-sell agreement to require a large down payment to decrease the amount of the payment that is deferred through use of installment payments.

Specify Installment Payments as the Funding Method in the Terms of the Buy-Sell Agreement

If installment payments are the chosen funding method, make sure that the buy-sell agreement specifies the principal amount (or method of determining the principal amount) and the interest rate (or method of selecting an interest rate). Include a time frame for the completion of the payments.

Tip: You might want to include a provision in the agreement that allows the funding method to be changed in the future. If it appears that installment payments might become less attractive, you might want the flexibility to change to another funding method or to use a combination of methods.

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Things to Do Later

Periodically Review the Agreement

You and your buy-sell participants should review the agreement on a regular basis, especially if terms specify an annual valuation of the business.

Tip: If it appears that the value of the business is increasing to levels that might make the amounts of the installments too large, you might consider adopting funding methods to be used in conjunction with or in place of installment payments.

Review Your Buyer's Finances (Are Installment Payments Still Possible?)

As part of the funding arrangement, you should routinely verify that the buyer is still in a position to make the installment payments. If the time comes when the use of installment payments appears less favorable, other funding can be arranged. Ongoing financial reviews can avoid unpleasant surprises later.

Tax Considerations

Income Tax

Tax Effect on the Seller--Lifetime Sale

Installment payments are divided into principal and interest components.

  • The portion of the installment payment that represents principal is treated as a capital gain to the extent it exceeds the seller's basis. If all requirements are satisfied, the recognition of the capital gain and the payment of the corresponding tax can be spread out over the installment payment period.
  • The portion of the installment payment that represents interest is treated as ordinary income, subject to ordinary income tax rates.

Tax Effect on the Seller's Estate

Upon the death of the seller of the property, the beneficiary who receives the installment note from the decedent must report the remaining payments in the same manner as the decedent did during life. In other words, the beneficiary must divide each payment that is received into a tax-free return of investment, gain, and taxable interest. The beneficiary will be allowed an income tax deduction to the extent that the seller's estate was liable for any estate taxes on the unpaid installments.

Tax Effect on the Buyer

The interest portion of installment payments may not be deductible to the buyer. In some instances, the interest paid by the buyer might be deductible, while in other cases it is not. One of the factors in determining if interest is deductible is the status of the buyer--for instance, material partner, passive investor, or the business itself. The following table shows how interest on installment payments is generally treated:

Buyer Is

Business Is

Interest Is

Conditions

Individual

Proprietorship

Deductible business expense

Assets bought for business

Surviving partner "material participant in business"

Partnership

Deductible business expense

Assets represented are used solely for business

Individual "material participant in business"

S Corporation

Deductible business expense

Assets represented are used solely for business

Individual

C Corporation

Generally subject to "investment-interest-expense limitations"

Not applicable

Passive investor

Not applicable

Not considered business expense, but may be deductible

Passive activity rules apply Interest treated as passive loss deductible only to extent of passive income

Business entity

S Corporation

May be deductible

Tested at shareholder level Deductible for material participants in business Passive activity rules apply. Deductions cannot exceed shareholder's adjusted tax basis in his or her S corporation stock

Business entity

Partnership or C Corporation

Deductible business expense

Not applicable

Gift and Estate Tax

Low Interest Rate Could Result In Unintended Gift Tax If Parties Are Related

The gift tax rules require that a market interest rate be charged on the installment payments to avoid gift taxes. As long as the seller requires and receives an interest rate that is at least the applicable federal rate, there should be no unintended taxable gift resulting from the undervaluation of the promissory note.

Unpaid Balance of Installment Obligation Included In Gross Estate

Generally, any unpaid balance on the installment obligation as of the date of the death of the seller is included in the gross estate. The unpaid balance is first adjusted for the effect of above- or below-market interest rate, and collectability.

Use of Installment Payments in Buy-Sell Can Affect Estate Tax Payments

By accepting the installment payment method for the sale of your business interest, your estate does not receive the ability to defer federal estate taxes attributable to the business. The federal estate tax attributable to the business could be due in a lump sum, while receipt of the proceeds from the sale is extended over a period of years.

Questions & Answers

What Happens If You Transferred Your Business During Your Lifetime, and You Die Before You Receive All of Your Installment Payments?

If you die before the installment period has been completed, the buyer still owes you the money. Payments would continue to your estate until the installment obligation is fully paid. The value of the unpaid balance, adjusted for market interest rates and collectability, is included in your gross estate.

How Is The Installment Payment Funding Method Different from the Private Annuity Funding Method?

Under both the installment payment and private annuity methods of buy-sell agreement funding, the seller receives payments for the business interest over some period of time. Both can be effective funding methods for the sale of a family business. There are some major differences between the two methods, however, as shown in the following table.

Characteristic

Installment Payments

Private Annuity

Is interest deductible for buyer?

If buyer material participant in business

No

Can payment be secured?

Yes

No

Do payments continue after death of seller?

Yes

No

Is the unpaid balance included in seller's estate?

Yes

No

 

 

This material was prepared by Broadridge Investor Communication Solutions, Inc., and does not necessarily represent the views of  The Retirement Group or FSC Financial Corp. This information should not be construed as investment advice. Neither the named Representatives nor Broker/Dealer gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. The publisher is not engaged in rendering legal, accounting or other professional services. If other expert assistance is needed, the reader is advised to engage the services of a competent professional. Please consult your Financial Advisor for further information or call 800-900-5867.

 

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