Family Lifetime Transfers
Buy-sell arrangements are the most commonly used estate planning strategies for small business owners. However, several other techniques are available — most are tax-motivated, though they may offer significant non-tax benefits depending on circumstances.
Until now the discussion has focused on transferring ownership upon the owner’s death. As an alternative, the owner could transfer the business during their lifetime. The decision to do so depends greatly on the owner’s willingness to relinquish control. Some owners wish to enjoy retirement; others want to relieve heirs from dealing with the business during estate settlement; still others use the lifetime transfer as an employee incentive or a way to foster family commitment to the business. A lifetime transfer may be a gift, a sale, or a combination of the two.
Gifts to Family Members
A key component of any estate plan calling for family retention of the business is proper grooming of the successor generation. A lifetime transfer of ownership can provide an incentive to encourage continued family commitment. The owner may wish to gradually transfer ownership to the next generation, either outright or through a trust.
The annual gift tax exclusion ($18,000 per recipient in 2024; $36,000 for married owners splitting gifts) allows tax-free transfers each year. For smaller businesses, successive annual gifts can transfer a significant portion of the business’s value without any gift tax consequences. These gifts:
- Pass without gift tax and are not added back to the estate at death (unlike gifts sheltered by the unified credit)
- Reduce the value of the owner’s eventual estate — intentional defunding
- Remove future appreciation from the owner’s estate — estate freezing
For larger enterprises, the owner’s lifetime applicable exclusion ($13.61 million in 2024) effectively allows transfer of a larger business interest without incurring current gift tax. Married owners can effectively double this amount by splitting the gift. However, use of the lifetime credit brings the original gift value back into the estate for tax purposes upon the donor’s death — only subsequent appreciation escapes both gift and estate tax, which is why this technique is called “estate freezing.”
Any lifetime gift of a business interest requires a formal valuation. If the gift’s value exceeds the annual exclusion, the IRS may challenge the valuation. However, a properly valued lifetime gift program can establish a business value acceptable to the IRS for eventual estate tax purposes.
Intrafamily Sales
A sale of a business interest to a family member has many advantages. One of its chief purposes is to freeze the value of the business in the owner’s estate. The most straightforward arrangement is an outright sale for cash at fair market value. Provided it is a bona fide business transaction for adequate consideration, a sale to a family member is valid for tax purposes and will likely result in capital gains for the seller. These arrangements require careful documentation, since intrafamily transactions are subject to close IRS scrutiny.
Bargain Sale
An owner may wish to sell for less than full current market value — a bargain sale. Under IRS rules, a bargain sale is treated as part sale and part gift. Any amount by which fair market value exceeds the sales price is a taxable gift from seller to buyer. For income tax purposes, the seller realizes a capital gain proportionate to the size of the actual sale.
Bargain Sale Example — Clara and John
Gift portion: $2,400,000 − $800,000 = $1,600,000 taxable gift
The transfer is one-third sale (800/2,400) and two-thirds gift.
Clara’s capital gain: $800,000 proceeds − (1/3 × $900,000 basis) = $800,000 − $300,000 = $500,000
John’s cost basis: $800,000 paid + $600,000 carryover basis on the gift portion (2/3 × $900,000) = $1,400,000
A bargain sale is a compromise between an outright gift and a straight sale. Its terms reflect the degree of the owner’s generosity.
Installment Sale
An installment sale allows the owner to transfer the business to a family member in exchange for periodic payments of principal and interest over time. Key benefits:
- Estate freezing — any appreciation after the sale accrues to the buyer and is outside the seller’s estate
- Capital gains spreading — the IRS permits the seller to spread capital gains over the life of the installment note; only the proportionate gain included in each payment is taxed in that year
- Stepped-up basis for the buyer — the buyer’s cost basis equals the full purchase price, better than the carryover basis received on a lifetime gift
- Interest deductibility — the interest portion of each payment may be tax-deductible for the buyer as a business expense
Installment Sale Example — Chuck and Eric
Capital gains treatment: In each of the next 10 years, Chuck reports $80,000 in capital gains (80% of each $100,000 payment). The gain is spread over 10 years rather than recognized all at once.
Eric’s basis: $1,000,000 — a step-up from Chuck’s $200,000 basis. (By contrast, a lifetime gift would have given Eric Chuck’s carryover basis.)
Note forgiveness: Chuck could forgive one or more of Eric’s annual payments in a later year. If Chuck forgives the entire $100,000 payment in Year 3, Chuck has made a taxable gift of $82,000 (after the $18,000 annual exclusion). The IRS permits this, provided there was a genuine intention to enforce the note at the time of the original sale.
Chuck’s estate: If Chuck dies while the note is outstanding, the present value of the remaining payments is included in his taxable estate. If he dies after full repayment, the current value of the business is excluded entirely from his estate (though the $1 million in sale proceeds may remain in the estate, directed to other heirs).
Private Annuity
A private annuity is a series of lifetime payments paid by someone other than an insurance or annuity company. Like the installment sale, the owner transfers the business in exchange for a promise of future payments — but the annuity payments continue for the seller’s lifetime and cease upon death. To qualify as a sale (not a gift), the present value of the annuity payments must adequately compensate for the transferred property. The IRS publishes actuarial tables based on life expectancy and current interest rates to determine the required payment amount.
Private Annuity Example — Chuck (Age 65) and Eric
Gift tax: None — the annuity payments fully compensate for the transferred property.
Capital gains: Chuck spreads the gain over the payment period (his lifetime), similar to an installment sale.
Estate planning benefit: Upon Chuck’s death, the annuity payments cease. There is no remaining value to include in his taxable estate — the business is entirely outside his estate.
Risk to the seller: If Chuck dies after only 3 years, Eric effectively purchased a $1 million business for only $441,371 (3 × $147,123.70) — a financial windfall for Eric, but Chuck’s wife and other heirs may be shortchanged.
Risk to the buyer: If Chuck lives 10 years, Eric pays more than $1.47 million for the business — not a bargain. These extra payments also increase the value of Chuck’s estate (an “anti-freeze” effect).
Critical restriction: Unlike an installment note, a private annuity must be unsecured — the IRS requires the seller to retain no rights in the transferred property. If Eric cannot make payments, Chuck has no recourse and no ability to reclaim the business.
Installment Sale vs. Private Annuity — Comparison
| Feature | Installment Sale | Private Annuity |
|---|---|---|
| Payments | Fixed number of payments until paid in full | Lifetime payments; cease at seller’s death |
| Estate inclusion at death | Remaining note balance included in estate | Nothing included; annuity ends at death |
| Security | Can be secured by the business assets | Must be unsecured; seller retains no property rights |
| Longevity risk | Seller receives full purchase price regardless | Buyer benefits if seller dies early; seller benefits if seller lives long |
| Capital gains | Spread over installment period | Spread over seller’s lifetime |
| Note forgiveness | Permitted (treated as gift) | Not applicable |
| Best for | Owner who wants security and may remain active | Owner in poor health (removes business from estate at minimal payment cost) |
Retained Interest & Split Purchases
All of the previous techniques require a total transfer of ownership by the owner — which may be unacceptable for owners who wish to retain control during their lifetimes. Two additional techniques allow the owner to freeze estate values, provide cash flow, and assist a family member in acquiring the business while retaining practical control.
Sale of a Remainder Interest
This technique splits the existing business interest into two components: a life interest (retained by the owner) and a remainder interest (sold to the family member). The owner retains the life interest — allowing practical ownership and control during their lifetime. The remainder interest represents ownership after the owner’s death; the family member purchases this portion and automatically inherits the business upon the owner’s death. The IRS publishes tables showing the value of a remainder interest based on the owner’s age and life expectancy.
Remainder Interest Sale Example — Tom and Jerry
Per IRS tables, the remainder interest at Tom’s age is 20.994% of the entire business value.
Jerry pays Tom: 20.994% × $200,000 = $41,998
Tom continues to operate the business as the holder of the life interest. Upon Tom’s death, Jerry becomes the sole owner automatically — similar to a buy-sell agreement, but the sale occurred during Tom’s lifetime.
Key estate tax benefit: The value of the business is not included in Tom’s estate. The life interest is worthless at death, so nothing remains to tax. The business’s full value — including any appreciation — passes to Jerry outside the taxable estate.
Funding flexibility: If Jerry doesn’t have $41,998 in cash, he could pay through installments or a private annuity, deferring capital gains recognition for Tom as described above. The property can also be placed in a trust first, creating a retained interest trust (RIT).
Split Purchases (SPLITs)
A split purchase (also called a joint purchase) is closely related to the sale of a remainder interest. In a split purchase, two parties buy an asset together — one purchasing the life interest, the other the remainder interest. This differs from a remainder interest sale in that both parties acquire their interests simultaneously from a third-party seller.
Split Purchase Example — Father and Daughter Buy a Building
Purchase price: $1,000,000
Per IRS actuarial tables at age 50:
• Father pays for the life interest: 84.743% = $847,430
• Daughter pays for the remainder: 15.257% = $152,570
No gift tax — both parties paid for their interests at actuarially correct amounts. Since the price was set by an outside seller, the IRS is unlikely to dispute the valuation.
Benefits to the father:
- ›The corporation leases the building from the father, who receives the full rental income from a $1 million asset despite paying less than 85% of the cost
- ›Takes the full depreciation deduction on the building’s value
- ›Can amortize the life interest itself — reducing income taxes further
- ›Paying maintenance and other expenses “defunds” the estate further
Disadvantages of Split Purchases
- Both parties must consent to sell or mortgage the property
- At advanced ages, the life interest’s actuarial value may be too small to be an effective planning tool
- No step-up in basis for the remainderman when the life interest holder dies (daughter’s basis remains her original $152,570)
- The remainderman must truly purchase the remainder interest with their own funds — if the life interest holder gives the remainderman the money to buy their share, the IRS treats the entire transaction as a taxable gift
- Any payment of non-actuarially correct amounts, property improvements, or debt repayments can also trigger gift tax consequences
- The property must be income-producing to qualify. Rental real estate works; stock in a closely held corporation does not.
Split Purchase for a Term of Years
Instead of a life interest (ending at death), the split purchase can be structured for a stated term of years. In the example above, the father and daughter could buy the building with the father taking all benefits for the first 10 years, after which the daughter takes full ownership. The father can amortize his interest over 10 years (instead of a longer life expectancy), further reducing income taxes. However, if the father dies within the 10-year term, any remaining property rights transfer within his estate for tax and probate purposes.
Summary — Lifetime Transfer Techniques
| Technique | Gift Tax | Capital Gains | Estate at Death | Owner Retains Control? |
|---|---|---|---|---|
| Annual Gifts | None (within exclusion) | None | Removed; no add-back | Partially |
| Gift using Unified Credit | None out-of-pocket | None | Original value added back; appreciation excluded | Partially |
| Outright Sale (FMV) | None | Immediate recognition | Proceeds in estate; appreciation excluded | No |
| Bargain Sale | Gift portion taxable | Proportionate recognition | Proceeds in estate; appreciation excluded | No |
| Installment Sale | None (if at FMV) | Spread over payment period | Remaining note balance included | Partially (phase-out) |
| Private Annuity | None (if properly valued) | Spread over lifetime | Nothing included (annuity ceases at death) | No (unsecured) |
| Remainder Interest Sale | None (if at IRS tables) | At time of sale | Life interest worthless at death; excluded | Yes — retains life interest |
| Split Purchase | None (if actuarially correct) | At time of sale | Life interest excluded at death | Yes — holds life interest |