Selling your business to family members can be a complex process, and having a well-structured Buy-Sell Agreement in place is essential to ensure a smooth and fair transaction.
What is a buy-sell agreement?
A buy-sell agreement is a legal contract common in closely held businesses. It is an agreement you can enter into now that provides for the future sale of your business interest. A buy-sell agreement is also referred to as a business continuation agreement, a stock purchase agreement, or a buyout agreement. When you carefully draft your buy-sell agreement, you can use it to set the taxable value of your business interest.
Does it matter if your buy-sell agreement is with a family member?
The IRS carefully reviews transactions among family members. Therefore, any business transaction between you and a family member might attract the attention of the IRS. Family member definition: spouse, parents, their descendants and spouses, and other beneficiaries chosen by the transferor.
There are rules in effect that can make the sale of an interest in a family business seem more difficult. However, you can take steps to ensure that your related party buy-sell agreement stands up to an IRS examination.
Considerations for buy-sell agreements with family members:
1. Make sure your buy-sell agreement price represents fair market value.
When setting the valuation method to be used under the buy-sell agreement, ensure that the transaction represents fair market value (FMV). Using a price higher or lower than FMV can lead to important tax consequences determined by the IRS. To ensure that the IRS accepts your sale price, your buy-sell agreement must meet three requirements:
- It must reflect a bona fide business arrangement,
- It must not be a device to transfer your interest to family members for less than full and adequate consideration,
- Its terms must compare with those of agreements between parties in an arms-length transaction.
A professional appraisal or valuation should be conducted to establish the FMV of your business interest.
2. Attribution rules may apply and affect tax treatment when the buyer is a family corporation.
If your buy-sell agreement is between you and the business entity itself (entity purchase buy-sell agreement), if shareholders are related to each other, and if your business is a corporation, the attribution rules of Section 318 must be considered. The definition of related shareholders includes spouse, parents of either spouse and their children and their spouses, and any natural objects of the transferor’s bounty. The attribution rules can affect the tax treatment of a shareholder’s stock redemption.
Depending upon the circumstances and the way the buy-sell is structured, the proceeds (payment) the seller receives from the redemption of the business interest may be classified as a sale or exchange of the seller’s interest (subject to capital gains tax) or as a dividend distribution.
Capital gains and qualified dividends are generally taxed at 0%, 15%, or 20%, depending on the amount of the individual’s taxable income. Also, an additional 3.8% Medicare tax applies to some or all of the 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.
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. In the case of dividend treatment, the entire amount paid to the shareholder is subject to tax. 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.
If the sale or exchange of your shares occurs after your death, your shares will generally have a basis equal to the fair market value of the shares at the time of your death, and little or no tax may result.
In a family corporation, the sale of stock to the business under a stock redemption plan usually results in dividend treatment to the redeeming shareholder.
Well-Structured Buy-Sell Agreements Promote Harmonious Transitions
A well-crafted Buy-Sell Agreement can provide a solid foundation for a successful business transfer within the family. By addressing these considerations upfront, you can mitigate potential challenges and foster a positive and harmonious transition process. However, always seek professional advice from legal and financial experts experienced in business sales to family members.
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