Making Cents: How do low interest rates benefit your family business
By: John P. Napolitano, CFP®, CPA, PFS, MST
There are many benefits to a low interest rate environment. The obvious ones are your lower cost of borrowing coupled with rising real estate prices. Less obvious ones are good for businesses in terms of borrowing or re-financing some of their existing debt. Some borrowers have been able to rid their business loans of personal guarantees in the process of refinancing.
The biggest beneficiary of low rates are those looking to get a business into the hands of the next generation and trim their ultimate estate tax bill. There are several ways in which low rates help those with assets in excess of the federal estate tax threshold of $11.18 million per person.
Today’s low rates make a technique called an estate freeze work a lot better. Let’s say that you have a valuable family business that you would like to see in the hands of the next generation. The estate freeze allows you to sell the business to those future operators today at its fair market value. This isn’t an area where you can wing it on the valuation. This is exactly when you need to have a formal valuation with adequate documentation to back up your position. In exchange for selling the company, you would hold a promissory note from the buyers.
Like any other promissory note, that note must bear a fair market rate of interest. The IRS recognizes that in many cases these business owners would charge no interest if they could get away with it. Therefore, the IRS published what is called the Applicable Federal Rate. The AFR is the minimum interest rate that must be charged for all related party financing transactions. Today’s AFR ranges from 0.15% on short term loans to 1.17% for long term loans. In my opinion, that is about as close to free as we’ll ever see. These rates change monthly, so don’t sit on this idea and watch rates rise, act soon.
The presumption here is that the underlying business will appreciate. In theory, any appreciation rate in excess of the interest cost is a win. But for a big win, you want to use this technique with a business that is appreciating at a pretty significant rate.
You can do this sale and not lose control of the company! That can be accomplished in many ways. One is to maintain a majority interest and only sell a partial interest. Another would be to appoint you as CEO for an extended period where you call the day to day shots while the loan is outstanding. You can also subject the sold shares to a voting trust whereby you maintain voting control over the sold shares until the note is paid.
This isn’t something that needs to be done by year end. But it should be done while rates are so low. If your attorney doesn’t do this type of work all the time, work with a planner who can help map out the strategy, and then find an attorney who is skilled specifically at these types of transactions.
John P. Napolitano CFP®, CPA is CEO of US Wealth Management in Braintree, MA. Visit JohnPNapolitano on LinkedIn or uswealthnapolitano.com. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor. US Wealth Management, US Financial Advisors and LPL Financial do not offer tax advice. John Napolitano is a registered principal with and securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through US Financial Advisors, a Registered Investment Advisor. US Financial Advisors and US Wealth Management are separate entities from LPL Financial. He can be reached at 781-849-9200.