“David” arrived at my office with a dilemma. “I’ve built my business from the ground up,” he told me, “worked it for forty years. I want to retire but two of my three children work in the business and are dependent on it for their livelihoods. I don’t want to work there anymore, but I can’t necessarily afford to hand them the keys for nothing.”

 David continued, “on the other hand, they might be resentful if I sell it to them for what it’s really worth. They’ll have to pay me a lot of money, and it might affect how much they can take home in these hard times. What do I do?”

 This is a real problem, especially today with the tight economy. I asked David if they’ve had the business recently appraised by a qualified business appraiser. He told me that his CPA gave him a figure a couple of years ago, based upon the company’s financial statements at the time.

 I suggested that we work with the CPA to currently appraise the business. Many CPAs are certified to perform business appraisals through a special license designation. If David’s CPA isn’t so licensed, or if the CPA feels that he may have a conflict of interest preparing the appraisal, then I suggested that David engage the services of a qualified business appraiser to determine the share price.

 Once the value of the business is determined, then some other hard decisions will have to be made. Is David willing to sell his full interest or some part of it? Does he wish to maintain some control over the operations of the business or will he simply become an outside consultant as needed? How will he secure his interest on the transfer to his two children so that some other creditor of the business will have priority over his interest?

 Taxes are also an issue. If David simply gifts his shares of the business to his two children, then he will have a taxable gift. If the value of all of his lifetime taxable gifts exceeds $1 million, then he will actually have to pay gift tax on the transfer. A gift is probably not his preferred course of action since David wants to be compensated for his interest in the business. He worked the business for forty years and will now depend upon the proceeds from the sale of the business to fund his retirement.

 But if David sells the business to his children, and if he wishes to defer the tax through an installment sale, he may have difficulties, especially if the children intend to sell the business to another party. This could trigger the full capital gain, even if the installment sale transaction note is not completely paid off.

 In any event, given the current economic conditions, David is mindful that the payments on the installment note may result in creating a cash flow problem. It will therefore be important to structure the payments to allow for payment reductions in such event. The security that David may want to protect his promissory note might also cause problems with the various lenders that have loaned the company money. Sometimes a sale between family members in such a transaction will cause the company to be in default of various loan covenants.

 Finally, David should be mindful how this affects his estate plan. Assuming that he no longer owns a business, but instead owns a promissory note, this is a very different type of an asset. The promissory note has capital gain attributed to it for one thing, and the formulas in David’s estate planning documents that are designed to minimize his estate tax could inadvertently trigger the premature recognition of the capital gain if those formulas are not adjusted to account for the different type of asset that David now owns.

 On top of that, one of David’s children does not work in the family business. If Daivd should die before the promissory note is paid in full, he will have to decide if he is going to leave that child other assets, or whether that child may one day inherit his share of the promissory note. These considerations should be carefully thought out. On the one hand, would it create family tension to make the one child a creditor of the business? Weight that against giving that child some other asset, such as the family home, stocks, bonds or mutual funds. The children inheriting the promissory note because they work in the business may feel that they only inherited a “job” that they paid for themselves.

 So there’s a lot to consider. The problems are not insurmountable. It’s good that David decided to address them at the beginning of the process rather than after he put everything in place.

 ©2009 Craig R. Hersch