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Spoil the child, spare the surtax

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in Small Business Tax,Small Business Tax Deduction Strategies

Are you planning to sell your business in the next few years? Although you might owe a hefty income tax bill on the value of an appreciated interest, at least you may be able to dodge the new 3.8% Medicare surtax on net investment income that is scheduled to take effect next year.

But what about your kids and other family members who are shareholders in your business? They could get walloped by the surtax.

Strategy: Hire family members who are shareholders (if they don’t already work for the company). Keep them on the payroll until you sell the business.

As a result, when the deal is finally closed, the relatives should be able to squeeze through the same tax loophole as you, the business owner, pending clarification of the rules.

Here’s the whole story: Under the 2010 health care law recently upheld by the U.S. Supreme Court, a 3.8% Medicare surtax takes effect in 2013. The surtax applies to the lesser of net investment income received by single filers with a modified adjusted gross income (MAGI) above $200,000 for single filers and $250,000 for joint filers.

For this purpose, “net investment income” includes interest, dividends, royalties, rents, gains from dispositions of property and income from passive activities, but not tax-free interest or distributions from qualified retirement plans and IRAs.

Another exclusion from the definition of “net investment income” is critical to family-owned businesses. It specifically doesn’t include gains from the sale of property owned in an active trade or business. That lets most working business owners off the hook. However, shareholders sitting on the sideline will have to face the surtax if the business is sold.

Example: Your small business is currently valued at $12 million with an adjusted basis of $2 million. You and your spouse own 80% of the business and the remaining 20% is split evenly between your two adult children. So each child currently owns shares worth $1.2 million with a basis of $200,000.  

Your oldest child works for the company, but your youngest child doesn’t. Assuming you sell the business for $12 million after 2012, each child will realize a gain of $1 million ($1.2 million – $200,000).

Under current understanding of the rules, the gain from the sale won’t be included in the oldest child’s net investment income for the surtax calculation. But the younger child may owe the 3.8% surtax on at least $1 million in net investment income (not even counting investment income from other sources), assuming the net investment income is less than the child’s excess MAGI. That comes to a surtax of $38,000 on top of the regular income tax!           

This harsh result can easily be avoided if you hire your younger child to work for the business.

Of course, this will have other ramifications, but overall it should be favorable to the family. For instance, the child will owe taxes on wages, but will be eligible for tax-free fringe benefits.

The job must be legitimate. You can’t avoid the surtax simply by putting the child on the books.

Tip: The IRS is expected to provide guidance on what constitutes gain from sale of property owned in an active trade or business. Stay tuned.

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