According to the Conway Center for Family Business, family businesses are responsible for 64 percent of the U.S. GDP. Moreover, they create 78 percent of all new jobs and generate 62 percent of the nation’s employment. Clearly, family businesses are nothing short of the backbone of America.
Family – A Risky Succession Plan
Despite the fact that 75 percent of family-owned companies intend to pass ownership to the next generation, 43 percent do not have a succession plan in place, as Forbes points out. If this sounds familiar, it’s time to give some real thought as to how to pass your manufacturing company on to your son or daughter. But if you’re thinking of helping him or her out by financing the acquisition, it’s important to understand that there are several risks involved.
Seller-Financed Buyout
It’s not unusual for parents to lend their children money so they can purchase a car or even a home. However, when you’re both selling an income-generating manufacturing company, to your child and at the same time lending him or her the money for the transaction, you’re effectively entering into a seller-financed buyout. Kiplinger reports that this setup creates an income stream for you – and that can be beneficial in your golden years.
It’s important to be aware of the fact that financial transactions between family members can become problematic. In any sale of a business, it’s not unusual for the seller to assign an unrealistically high value to his or her company. At the same time, a son or daughter might feel like they shouldn’t have to pay full price for the acquisition because “we’re family.” Moreover, in some cases, families value a company based on the income the seller needs in order to retire comfortably. The resulting sum is frequently far from realistic — it’s either too high or too low. To avoid these types of issues, Entrepreneur recommends involving an experienced business appraiser who can objectively assess the manufacturing company and provide a realistic value.
Applicable Federal Rate
If you’re financing the acquisition, you have to charge your son or daughter an interest rate that’s close to the applicable federal rate — or AFR. MarketWatch states that if you don’t, the loan is considered a below market loan. When this happens, the IRS calculates the difference between the rate you should have charged and the rate you actually charged. Your son or daughter has to pay the resulting sum back — in theory — as imputed interest income. In addition, you have to report it as taxable income on your tax return.
Income in Respect of a Decedent (IRD)
There’s another potential tax issue that could come up when financing the acquisition of your business by your son or daughter. If you pass away before the end of the loan term, it could result in the levying of income tax on your estate, as well as an unexpected financial burden to your other children, as Forbes reports.
For example, let’s say you finance the acquisition and provide in your will for forgiveness of the debt in the event you pass away. Your intention is that your child can take over the business without any further debt and that he or she plus the children who aren’t involved in the company divide the remaining estate. However, by forgiving the debt, the income of the estate is accelerated. The resulting capital gains are considered income in respect of a decedent — or IRD — and are taxable.
The situation can become even more complicated in the event your will doesn’t specify that this tax diminishes your child’s portion of the estate. Consequently, all of your children will be equal beneficiaries of the estate and incur an equal tax burden. This means that the children who aren’t involved in the manufacturing company are left paying for their share of the IRD from their sibling’s business loan. Obviously, this could lead to discord among your children — at a time when they should be bonding together as a family.
Selling Your Manufacturing Company by Working With a Specialized Business Broker
It should be clear that selling your manufacturing company to a family member and at the same time financing the acquisition is rife with pitfalls, both for you and the buyer. As such, it’s wise to not underestimate the complexity of this type of deal. Instead, work with a business broker who specializes in family transactions in the manufacturing sector.
Additionally, consider getting professional legal and tax advice. By approaching the transaction with the same caution and professionalism you would when selling to an external party, you can ensure that both you and your family member gain what you want from the deal.