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Using Life Insurance to Protect a Business Installment Sale

July 7, 2017

 

Borrowing Funds to Buy a Business

 

An important option for financing the purchase of a business interest under a buy-sell plan is the use of debt instruments. Often, the buyer has insufficient cash reserves for an outright purchase. As an alternative, the buyer may finance the purchase by giving the seller a promissory note or similar instrument representing the buyer's obligation to make a series of payments.

 

Selling for Periodic Payments

 

In an installment sale, a buyer agrees to pay the purchase price in periodic installments of principal and interest over a specified period of time. The IRS has mandated that the minimum interest rate on a bona-fide installment sale is the Applicable Federal Rate (AFR). However, a higher rate of interest can be used.

 

The buyer and the seller negotiate the parameters of the installment sale, including the duration of the note, the frequency and structure of the payments, and the composition of principal and interest.

 

Taxation of Interest

 

Interest paid to the seller on an installment obligation is generally taxed to the seller as ordinary income.

 

Deductibility of Interest

 

Interest payments may be deductible (subject to certain limitations) as a business or investment interest expense by the buyer.

 

Eligibility for Installment Reporting

 

Generally, the seller may report any gain recognized on the installment sale of a business interest on an installment basis. The seller recognizes a share of the total gain recognized on the sale in each taxable year. The key exceptions applicable to installment reporting treatment of installment sales are:

  1. Sales of publicly traded shares or securities

  2. Sales of property subject to depreciation recapture

  3. Sales with more than $5,000,000 of installment debt

In these situations, the seller may be required to report all or a portion of the gain immediately.

 

Planning for Contingencies

 

The buyer may die before all of the installment payments have been made. Life insurance offers a way to ensure that the buyer's full debt obligation will be met, and is required by many buy-sell plans.

 

Considerations

 

  • Intra-family Installment Sales have come under scrutiny by the IRS. In some instances, the IRS has disqualified the sale of a business interest to a family member when it did not believe the transaction to be valid under Section 302.
     

  • The unpaid balance of the note the seller holds is includable in his/her taxable estate. A self-cancelling installment note (SCIN) is a specialized debt instrument that can solve this problem. A SCIN terminates either at the date of full satisfaction or at the date of the seller's death.

 

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