Chicago family business sales: buy-sell deals, tax and notes

What to take away

A family sale starts with the buy-sell agreement

A second-generation owner in Chicago seldom wakes up and decides to sell. The trigger is usually a death, a retirement date or a sibling who wants out, and the document that governs all three is the buy-sell agreement, signed years earlier when nobody expected it to matter.

A workable buy-sell agreement answers four questions. Who may buy the interest? At what price? When must the sale close? Who funds it? If any answer is blank, the family negotiates under pressure, often with a grieving spouse on one side and a bank on the other.

Chicago's manufacturing and logistics families often hold real estate in a separate LLC. If the buy-sell agreement covers only the operating company, the surviving owners can end up buying a business that rents its building from an heir who wants market rate. Spell out the real estate separately.

Owners who plan ahead treat the agreement as part of seller preparation rather than a document to revisit at closing. That means updating the price every year, confirming the funding source still exists and checking that the entity type in the agreement matches the entity that exists today.

Pick the pricing method before the event

Pricing methods fall into three groups: a fixed price reviewed annually, a formula tied to book value or earnings, and an appraisal at the time of the event. Fixed prices go stale. Formulas are cheap but crude. Appraisals are accurate and slow.

The method decides which weakness the family lives with. A fixed price nobody has updated invites an argument about what the business is worth now. A formula can miss a lost customer or a new lease. An appraisal takes time that a grieving family may not have.

Whichever method the agreement uses, it should say what happens when the price cannot be agreed. A silent agreement leaves the family to settle on a number, or to hire an appraiser, at the worst possible time.

Decide how the buyout will be funded

Life insurance is the usual funding tool, but the policy must be owned correctly. A policy owned by the insured, payable to the estate, is included in the taxable estate. An irrevocable life insurance trust can keep the proceeds outside it, if the trust is drafted and funded properly.

Insurance is also a failure point. A policy bought to fund a $2 million buyout in 2010 may now cover a fraction of a $6 million obligation. Review the death benefit against the current appraisal every few years.

Cash from the company is the other source. A redemption needs enough of it, or enough financing, and where the buyer is family the seller often takes a note instead. The note terms are covered below.

Choose the route: redemption, cross-purchase or key employee

Once the family agrees on a price, the structure decides who pays tax and when. Three routes dominate Chicago family handovers: a redemption, a cross-purchase and a sale to a key employee. Each gives the seller and the surviving owners a different tax result.

A redemption is taxed as a sale only if it meets the tests in IRC Section 302, such as a complete termination of the shareholder's interest. If it does not, the payment is taxed as a dividend, a worse result for the seller.

IRC Section 303 gives a narrow second route for a redemption used to pay death taxes, funeral costs and administration expenses.

A cross-purchase has the remaining owners buy the interest individually. Each buyer gets a stepped-up basis in the acquired shares, which helps them later. The drawback is administrative: every owner needs a policy on every other owner.

A sale to a key employee or an outside manager brings fresh capital and often a lender. It also brings a buyer who will demand asset sale versus share sale clarity before signing. Asset deals let the buyer step up basis; share deals keep contracts and licenses intact.

The choice also affects the entity. A C corporation sale can trigger double tax, while an S corporation or partnership generally passes gain through once. The paperwork that follows an asset deal is covered in Form 8594 paperwork.

Whichever route is chosen, run the numbers for each party, not just the seller. A structure that saves the seller tax but leaves the buyer without deductible payments often collapses in negotiation.

Installment and note terms when family buys family out

Family buyers rarely pay cash, so the seller usually takes a promissory note, and the note terms carry as much risk as the price. An installment sale is a sale of property in which the seller receives at least one payment after the tax year of the sale.

The seller may report part of the gain as each payment arrives. That spreads the tax over years and can keep the seller in a lower bracket.

Interest matters. A note with no stated interest, or interest below the applicable federal rate, can be recharacterized by the IRS as part interest and part principal. Set the rate in writing at or above the applicable federal rate for the note's term.

The IRS publishes those rates every month as revenue rulings under IRC Section 1274(d), with separate figures for short-term, mid-term and long-term obligations. Use the rate for the month the note is made.

Security matters too. A seller who finances a family buyout should hold a security interest in the company's assets and file a UCC financing statement. Without it, the seller is an unsecured creditor behind the bank.

Terms to settle before signing:

A seller who expects the buyer to grow the business may want a contingent piece of the price. That is an earnout, and it is worth reading how seller notes and earnouts work before agreeing to a formula that depends on accounting choices the buyer controls.

What the buy-sell price means for the estate tax value

A 20 percent stake in a Chicago tool-and-die shop is not worth 20 percent of the shop. Two discounts explain the gap, a minority discount and a marketability discount, and both are standard in family transfers.

Discounts are not automatic. They need a qualified appraisal prepared under a recognized business valuation standard, such as the Uniform Standards of Professional Appraisal Practice. The appraisal must describe the company, the industry and the specific restrictions in the governing documents. A generic percentage pulled from a survey will not survive an audit.

In the example behind the figure, a $10 million firm gives a 25 percent owner a proportionate $2.5 million. The two discounts bring that to $1.5 million, and the taxable gift or estate value drops by $1 million.

The IRS can attack either discount. The stronger the appraisal, the stronger the position. Keep the valuation date, the standard of value and the assumptions in writing, and use the same appraiser for the buy-sell price and the estate filing where possible.

The authorities behind those discounts are worth naming. Revenue Ruling 59-60 is the IRS's own guide to valuing closely held stock. Estate valuation sits in IRC Section 2031, and IRC Section 2704 limits discounts that rest on lapsing voting or liquidation rights.

Illinois and federal estate tax filings

Illinois is one of the states that still levies its own estate tax, under the Illinois Estate and Generation-Skipping Transfer Tax Act, 35 ILCS 405/. The Illinois estate tax threshold is $4 million per person, the figure that statute sets.

The federal estate tax applies on its own schedule, with an exclusion the IRS restates for each tax year, so a Chicago family can owe Illinois tax while owing nothing federally.

The Illinois tax is not a flat percentage of the excess. It is calculated from a rate table that rises with the size of the estate, set out in the statute and tied to the state death tax credit as it stood in federal law on December 31, 2001.

An estate just over the threshold can face a marginal cost well above the headline rate.

Illinois returns are filed on Form 700, the Illinois Estate and Generation-Skipping Transfer Tax Return, with the Illinois Attorney General's office, generally due nine months after the date of death, with an extension available on request.

On the federal side, the executor of a decedent's estate uses Form 706 to figure the estate tax imposed by Chapter 11 of the Internal Revenue Code. That return is also due nine months after the date of death, with a six-month extension to file.

Lifetime gifts are reported on Form 709, United States Gift (and Generation-Skipping Transfer) Tax Return, due April 15 of the year after the gift. The federal exclusion is indexed, and the IRS restates it for each tax year in a revenue procedure.

The amount that counts is the one published for the year of the gift or the year of death. The step-down in the federal exclusion that was once scheduled for 2026 has been repealed, which leaves that annual indexation as the only thing that moves the figure from year to year.

Illinois has no portability for its own tax the way the federal system does. A surviving spouse cannot simply inherit an unused Illinois exclusion. That makes credit shelter planning and the timing of gifts more important here than in states with no estate tax.

Business interests sit inside this calculation. The value used for Illinois estate tax purposes is generally the same fair market value used federally, which is why the discounts matter twice. A lower appraised value reduces both bills.

Connecticut, Massachusetts, New York, Oregon and Washington also impose estate or inheritance taxes, so a Chicago owner with a second home or a business interest outside Illinois should map every state that can tax the transfer.

Where the deal stalls: appraisals, insurance and lender consent

Most Chicago family handovers that fail do not fail on price. They fail on paperwork that was never updated, and each of these items is cheaper to fix before the trigger event than after it.

Appraisals go stale fastest. A valuation prepared for a 2022 gift may not reflect a 2026 revenue mix, a lost customer or a new lease. A stale number invites an audit and a penalty.

Lender consent is the quiet killer. A bank that holds a blanket lien on receivables and equipment can call a default when shares change hands without notice. The consents and handover checklist shows what to line up before the transfer.

Disputes that reach court are expensive and public. Valuation fights with the IRS are heard in the U.S. Tax Court, and fights among family members usually land in the Circuit Court of Cook County. A clean agreement is cheaper than a lawsuit.

Owners who want a second opinion on the numbers can work through a seller preparation checklist with their CPA before the appraisal is ordered.

Common questions