Loan to family business could trigger higher estate tax

From 1997 to 2003, a family could take an estate tax deduction of up to $675,000 if more than half of the estate property consisted of interest in a family business.  This law is scheduled to go back into effect in 2010, so it’s wise to be aware of it.

In particular, you should be aware that certain business decisions you make now- such as making personal loans to your company as opposed to capital contributions – could determine whether your heirs can claim the deduction.

A recent case involved the Farnam family, who owned a chain of auto-parts store in Minnesota, North Dakota and South Dakota.  To help grow the company, the family members made a number of loans to the business.

When the founder, Duane Farnam, died, he owned stock in the company, and he also owned notes representing loans he had made to the business.  A dispute arose with the IRS over whether the notes were an “interest” in the business. 

The reason? If the notes were an interest in the business, then combined with the stock, Farnam’s interest in the business was more than half of his estate, and his heirs could claim the $675,000 deduction.  But if they weren’t, then Farnam’s interest in the business was less than half of the estate and the deduction would be lost.

The U.S. Tax Court sided with the IRS.  It said the loans were not an “interest” since they didn’t represent a form of ownership or equity in the company.  They just represented an obligation to pay.  This is a sad result, since the purpose of the law was to reduce the pressure to sell a family business to pay estate taxes when the founder dies.  The Tax Court’s decision makes it more likely that families like the Farnams will have to sell the business they spent their lives creating just to pay off Uncle Sam.

The IRS, by the way, argues that families like the Farnams wouldn’t necessarily have to sell an equity interest in the business.  They might be able to pay their tax debt simply by selling the notes.

But that assumes that someone would be willing to buy the notes at a reasonable price.  And it also saddles the family with less friendly creditors who are more interested in getting paid than in the long term welfare of the company. 

The bottom line, though is that if you have a family business, its not always possible to separate business decisions from estate-planning decisions.  We can help advise you about the implications of your business planning for your estate planning.

Of course, the tax tail shouldn’t wag the business dog, but we can keep you informed of the full effect of your choices, and in some cases we may be able to suggest alternative ways to achieve business results that have better tax consequences for your family.

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