Thursday, February 20, 2003

All In The Family

The United States Court of Appeals for the Sixth Circuit issued an opinion Wednesday that suggests a strategy for the possibility of minimization of estate tax.

Under the facts of the case, Estate of Costanza v. Commissioner, (that’s Duilio, not George), a father sold his business to his son in exchange for a self-canceling installment note. The note required that the son make regular installment payments, but provided that any balance due at the time of the father's death would be automatically canceled. The father died five months after the consummation of the transaction and the execution of the note. The Service attempted to include the value of the note in the father's estate for federal estate tax purposes, arguing that the transaction that gave rise to the promissory note was not a bona fide transaction. Alternatively, the Service argued that the transaction was a "bargain sale" which gave rise to a taxable gift on the difference between the value of the note taken back and the actual (presumably, higher) value of the business purchased by the son.

The court rejected the Service's argument, pointing out that, at the time the note was executed, the father had a fairly substantial life expectancy. (He died from unanticipated complications that arose during open heart surgery.) And, most importantly, there was a clear expectancy that the note would be paid in the ordinary course, an expectancy that was not met only because of the father's premature death. As evidence, the court noted that the payments with respect to the first quarter of the note had, in fact, been made.

The court remanded for further proceedings the bargain sale issue.

The opinion opens the possibility of taking the value of a family business out of a taxable estate. Of course, there are income tax issues since the father's death caused the son to recognize cancellation of indebtedness income. However, the income tax issues are frequently more manageable since the marginal tax rates are often low. Moreover, the tax on the income that has to be recognized can be partially offset by depreciation or amortization of the asset that is acquired.

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