How to Handle an Inherited Business
Inheriting a family business can be a great honor. However, the risks of such a legacy can quickly outweigh the rewards when there's a void in leadership or a failure to prepare for estate taxes.
"Too often, owners don't properly plan for succession or the attendant tax hit, forcing heirs to make tough decisions about the business's future," says Austin Jarvis, director of trust, tax, and estate at the Schwab Center for Financial Research. "While there's no substitute for proper planning, there are options that can help beneficiaries navigate the tax bill, in particular, without resorting to a fire sale."
Here's how to handle an inherited business—from assessing its viability to handling taxes the company can't afford to pay.
1. Assess its prospects
First, determine if the business is something you can perpetuate successfully. "A business based on the decedent's expertise or established relationships, for example, could prove challenging for heirs," Austin says. "Unless you were mentored by the owner and immersed in the daily business operations, it can be extremely difficult to pick up where they left off."
Also consider the company's future revenue potential. "You want to be sure the business has the capacity, under your guidance, to generate net income," Austin says. Working with a business consultant can provide an unbiased assessment of the company's current viability and future prospects.
2. Determine its value
All assets in the estate, including the business, must be assessed for tax purposes. Although taxes typically are based on the assets' value on the date of the estate owner's death, they don't have to be—an important consideration for inherited businesses whose long-term outlooks may be in question.
Estates are allowed to elect an alternate valuation date if the worth of the assets decreases within six months of the decedent's death. "You don't want to make any final decisions about the future of the business until that six-month mark, when you know where things stand," Austin says. "If the value declines during that time, the associated tax bill could shrink or go away altogether."
You can still use the date-of-death value for tax purposes should it increase thereafter. You typically have nine months after the owner's passing to pay estate taxes, but it's common practice to request a six-month extension, giving you a full 15 months to determine the best way to address the tax bill.
3. Consider your tax options
If you decide to maintain the business but lack the liquidity to pay taxes, you generally have three options:
Defer the tax bill
Section 6166 of the U.S. tax code allows inheritors to defer taxes for up to five years, with interest, and to take 10 years after that to pay in installments, if:
- The business is "closely held," which applies to sole proprietorships as well as partnerships in which the decedent's ownership portion represents 20% or more of the business, and
- The business represents 35% or more of the decedent's taxable estate.
"In the wealth management world, we call Section 6166 the 'no-plan plan,'" Austin says. "It can make the tax bill more manageable by spreading it over many years, but you're also paying nondeductible interest on the deferred amount, which is not a great position to be in."
Be aware, too, that certain actions during the deferral period can accelerate repayment. If you miss a payment by more than six months or sell a majority share of the business, for example, the deferral agreement will terminate, and the remaining unpaid portion of the tax will immediately come due.
Request a hardship extension
If a business doesn't qualify for deferral, the executor may be able to request a hardship extension. To qualify, the executor must demonstrate need, which falls into one of two categories:
- Reasonable cause: If the estate is able to pay but does not have immediate access to the funds—which can happen when assets are tied up in litigation or the executor does not yet control them—an extension of up to 12 months may be granted.
- Undue hardship: If payment of taxes would cause significant harm to the estate—perhaps because it would require liquidating the business or selling assets at a loss—an extension of up to 10 years may be granted.
Like a Section 6166 deferral, interest accrues during the extension period. Unlike a deferral, however, interest is tax-deductible as an expense of the decedent's estate.
Take out a loan
If the estate doesn't qualify for deferral or extension, taking out a Graegin loan—so named for the court case that established the precedent—would allow the estate to pay the tax bill immediately and deduct the interest paid from its taxable value. In order for the interest to be tax-deductible, the estate must be able to prove that the loan was "necessarily incurred," typically because it allowed the heir to avoid liquidating assets. Furthermore, the deduction is allowed only for taxes incurred on the illiquid portion of the estate.
"The tax advantages of a Graegin loan can be attractive, but they're not a sure bet," Austin says. If the estate borrows from a private bank, for example, it must prove its creditworthiness just like any other borrower. And if the bank believes the estate is overextended or cannot reasonably repay the debt, it could reject the application, leaving heirs in a tough spot.
An estate may instead choose to borrow from a family member or an irrevocable trust; however, the loan must have clear terms and a fixed interest rate as well as prohibit early repayment. "The IRS is quick to challenge questionable loans, so be sure it's absolutely necessary and carefully drafted to stand up to potential scrutiny," Austin says.
"In a perfect world, a business owner would purchase a life insurance policy specifically to pay taxes and avoid forcing heirs to choose from these largely undesirable options," Austin says. "If you do decide to keep the business going, be sure to think about what will happen after you pass—then put a plan in place to keep your heirs from facing unintended tax predicaments."
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.
Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.
This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.0323-2USC