If you sell your business you might owe a hefty income tax on the appreciated interest.

Saving grace: At least you may be able to avoid the 3.8% Medicare surtax on net investment income (NII), depending on the exact circumstances.

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

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

As a result, when the deal finally closes, the relatives with business interests should be able to squeeze through the same tax loophole as you, the business owner.

Here’s the whole story: TheĀ 3.8% surtax applies to the lesser of NII or the excess above modified adjusted gross income (MAGI) of $200,000 for single filers and $250,000 for joint filers. For this purpose, NII 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 NII is critical to many family-owned businesses. It specifically doesn’t include gains from the sale of property owned in an active trade or business that is not a C Corporation.

That lets many owners who operate their businesses as Sole Proprietorship, LLCs, Partnerships and S Corporations off the hook. However, owners of these businesses who sit on the sideline will have to face the surtax if the business is sold.

Example: Your small business is operated as an S Corp and 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, a son and a daughter. So each child currently owns shares worth $1.2 million with a basis of $200,000.

Your son already works for the company, but your daughter doesn’t. Assuming you sell the business for $12 million, each child will reconize a taxable gain of $1 million ($1.2 million – $200,000).

According to the regulations, the gain from the sale won’t count as NII for your son because he is a material participant in the business. But your daughter will probably owe the 3.8% surtax on at least $1 million of NII (not even counting investment income from other sources). That comes to $38,000 on top of the regular income tax

This harsh result can easily be avoided if you hire your daughter to work for the business. Your daughter will owe taxes on wages, but will be eligible for tax-free fringe benefits.

Tip: The job must be legitimate. The surtax can’t be avoided simply by putting a child on the books.

At Bourke Accounting we can help you negotiate the murky waters of tax law. Give us a call at 502-451-8773 and make your appointment today to work through any and all tax issues.