Turning a business over to kids

[Jesse]

Taxpayer would like to turn an excavating business over to kids.

Option 1: Gift to kids – they will need to file a gift tax return but no gift tax will be owed.
Disadvantage – Parents give up all control over business.

Option 2: Set up an installment plan for kids to buy business.
Disadvantage – kids do not have money for down payment and there would be a hefty tax bill for the parents as there is much depreciation that will be recaptured as ordinary income. Also parents will be giving up the control.

Option 3: Lease with option to purchase.
Is this possible? Or would it be looked upon as an installment sale?
-If parents do not like how the kids run the business they can take it back at lease end.
-If things go good for kids they can hopefully save money to obtain a loan or a down payment to cover parent’s income taxes.

Any other options?
Any feedback would greatly be appreciated.

[DaveO]

Is the business a corporation? If so they could gift the stock slowly while the kids take control.

Another option would be for the parents to maintain ownership of the equipment and rent it to the kids while gving up control of the business. This would afford them an income stream without having to recap the depreciation.

[Jesse]

Thanks Dave,
No the business is a sole proprietorship.

With option 3 lease agreement is the way I'm leaning. They could lease the equipment at fair rental value with the option to buy after a year(or more?).

If my thinking correctly the lease payments would then be subject to SE Tax and the parents would continue to depreciate the equipment.

The kids would be able to deduct the lease payments and reap the benefits from the business. If they still can't obtain a loan or save up a large enough down payment they can renew the lease or walk away(or parents can opt not to renew the lease).

What I want to make sure is that I am not missing something that might make the transaction a disguised sale.

I'll also note they are working with a lawyer for future medicare planning and he likes option 1 because after 5 years "the nursing home won't get the business". I'm trying to tell them they can't have the best of both worlds and tax laws and estate asset planning will contradict each other.

[erchess]

Estate Planning

A long time ago I started a thread on estate planning and while there were many opinions kicked around I personally was convinced by the argument that before I let my parents have the kind of care they would get after spending down to medicaid I would impoverish myself. If that is the way these children feel then there is no reason to worry about "so the nursing home won't get the business".

[Jesse]

Actually it's the parents that are worried, not the children.

But irregardless I'm concerned with the ramifications of turning the business over to the children from an income tax standpoint. I can give my opinion, the lawyer can give his opinion, then it's up to the taxpayers to make a choice.

If this were your client would you suggest option 1,2, 3 or something other?

[ChEAr$]

Equipment in such a business like this has perhaps/ probably/ maybe been depreciated down to close to zero, right?

Remember that basis of depreciable property of a gift is tax adjusted basis.
Of course for gift tax purposes, form 70... ? it's FMV.

I don't recall seeing anything above relating to whether kids really want the business, or are even qualified to run it.

Run it. RUN it into the ground.
ahh. .. excavating business. of course.

[Jesse]

Equipment in such a business like this has perhaps/ probably/ maybe been depreciated down to close to zero, right?

Correct.

Remember that basis of depreciable property of a gift is tax adjusted basis.
Of course for gift tax purposes, form 70... ? it's FMV.

This option is more beneficial to lawyer, less beneficial to taxpayer. Also if they aquire by gift vs. inheritance, no stepped up basis.

I don't recall seeing anything above relating to whether kids really want the business, or are even qualified to run it.

Yes, the kids do operate some of the equipment but not the everyday activities of bookkeeping, payroll and other important daily responsibilities.

So they think they know it all, but the grass isn't always greener on the other side.

Run it. RUN it into the ground.
ahh. .. excavating business. of course.

Ha, Ha, good one!

[Lion]

Hire Kids

Why don't parents continue to own business for retirement income, hire kids, and gradually give kids more responsibility and higher salaries if business improves? Someday the kids will inherit with stepped up basis. In the meantime, parents continue to control and protect business and earn retirement income, hopefully enough income to make their own care decisions. Kids get paid for their work, weren't given something for nothing. Kids can squabble over who works hardest after parents are gone, so parents don't have to listen to it.

Or, spend their income as they make it on what they've saved for all their lives, travel, whatever. Let the kids earn their own livings!

[Jesse]

They definitely want to turn it over to the kids or get out of business. If it would not work out they are talking about trying to sell business as a whole or liquidate and if they did this they will have money on hand to pay any income tax. The kids just don't have the money up front.

Do you think a lease with option to purchase would work? Or would it be looked upon as an installment sale?

Again, the kids would be able to deduct the lease payments and reap the benefits from the business. If they still can't obtain a loan or save up a large enough down payment they can renew the lease or walk away(or parents can opt not to renew the lease).

-If parents do not like how the kids run the business they can take it back at lease end and sell to someone else, have an auction, whatever.
-If things go good for kids they can hopefully save money to obtain a loan or a down payment to cover parent’s income taxes because there is a sizable amount of depreciation recapture.

EDIT: The kids are now employees, but they don't take care of the administrative work. Sometimes that can be overwhelming, hence the hesitation.

[ChEAr$]

One more example, Jesse.

I once had an excavator. He loved his work, made money and ate well. Ate TOO well;
became obese. His son worked with him, and it was "like father, like son." Father operated as a proprietorship.

It was evident though that father was ailing, even had diabetes and back trouble, and even though he hadn't had me do tax returns for him a couple of years, I'd heard he was looking to file for Social security disability. And he did.

Third year he comes to me, saying he needs a letter for his son to give to mortgage company relative to son's buying house from father. The letter from accountant was needed to prove that son had no ownership interest in the business.

Don't have to tell you what I didn't do. But this all reminds me, that perhaps parents
merely want to have the business in childrens' name(s) so they can put in for either
disability or regular social security at age 62.

[Jesse]

One parent is 66 and the other is 67, already collecting social security and truly ready to retire.

Any thoughts on the lease w/option to buy agreement?

Anyone?

I'm not looking for someone to do my research for me, but if I'm overlooking something point me in a different direction.

[DaveO]

Why not just do a lease on the equipment and leave out the option to buy? That way there is no issue of a sale or recapture. If the parents can step back from the business after a year then the rental income is passive and not subject to SE tax.

I've seen this done with several family businesses. Usually there is some real estate involved that continues to be owned by the parents and rented by the kids for the business. After their death it passes tax free with stepped up basis, same as the equipment.

If the kids fail to run and/or grow the business the parents can still sell the equipment or rent it to another operator.

[Jesse]

Why not just do a lease on the equipment and leave out the option to buy? That way there is no issue of a sale or recapture. If the parents can step back from the business after a year then the rental income is passive and not subject to SE tax.

Dah - something so simple, I did not think to leave out the option to purchase. I don't see why that wouldn't work.

If the equipment rented with a profit motive although not actively participating wouldn't it be subject to SE.

If not, would you report on line 21 with no depreciation allowed or allowable?

I'm thinking out loud, I'll try to do some research.

[DaveO]

Income on Line 21 and depreciation reported on Line 36 with note of PPR. This will not allow the return to be efiled if that's an issue. If real estate involved then on Schedule E of course. They should take steps to demonstrate that they have no material participation, have kids establish new bank accounts, no involvment in decision making etc.

[CinSee]

Keep in mind depending on how the kids handle the business there might not be a business worth taking back!