For many business owners, retirement is the last thing on their minds until it is staring them in the face. Most business owners are kept occupied with the day-to-day operations of their business. Yet, retirement is an inevitable event that will eventually come, no matter how long it is put off. So it’s important to start planning now.
An ideal way for businesses to transfer ownership is to pass the business down to the next generation of family members, but this can present its own set of challenges. One particular challenge is how to finance the transaction. Without a solid plan, the process can stall and result in stress or family strife.
Curious as to how to properly transfer your family business to another family member, considering all financing routes? Here are four things business owners should keep in mind when planning to transfer ownership to the next generation:
1. Should you sell the business to a family member or give it as a gift?
A key element of a family business ownership transfer is whether or not the retiring shareholder needs to derive value from the business.
If the selling shareholder has sufficient assets to live out the remainder of his or her life, then why bother selling the company to the next generation? A sale would potentially put more assets into the shareholder’s estate, which would be subject to the estate tax before ultimately ending up with their heirs.
If the selling shareholder has sufficient assets, then gifting stock may serve as an option to transfer family business ownership, especially if it is important to keep the company within the family. Learn more about Gifting Strategies to Minimize Your Tax Bill.
2. Is it better for your inheriting family member to do an installment sale; AKA pay in installments?
If the selling shareholding family member needs proceeds from the business in order to retire comfortably, then a straight sale may be necessary. However, it is not uncommon for the purchasing shareholder to not have the funds readily available.
While the company may be able to borrow some funds (10 to 15 percent) in order to provide a down payment, the rest of the transaction price may need to be financed by a seller note. In this situation, the buyer will use future profits or distributions from the business to satisfy the obligation to the selling shareholder. This means, over time the new owner will make regular payments, or installments, which may reduce the seller's federal tax burden.
3. If the family member inheriting the company already owns part of the business, could you do a stock redemption agreement?
In a stock redemption transaction, the retiring family shareholder will have their shares redeemed by the business over a period of time. The next generation would presumably already own a portion of the company; for example, 10 percent of outstanding shares. Then each year, the retiring shareholder can sell a portion of his or her shares back to the company, slowly increasing the next generation’s percentage of the family business’s ownership.
A stock redemption agreement allows for discretion each year but also requires the shares to be appropriately valued each time. Learn more about stock redemptions and other Capital Allocations for Family Businesses.
4. Should you set up a deferred compensation plan to lower the equity and create a tax deduction?
Another common method among privately-owned businesses is to utilize compensation arrangements to provide for retirement to exiting shareholders.
By setting up a deferred compensation plan, the company can achieve two important objectives:
- Lower the company’s equity value due to the addition of the deferred compensation obligation to the exiting owner, which will make it easier to sell shares to the next generation.
- Create a tax deduction for the business when it is paying the deferred compensation to the selling shareholder after he or she retires.
A deferred compensation plan is useful when the retiring owner is actively working in the family business.
Set Your Family Business Up for Long-term Success
Retiring shareholders have options when looking to transition their business to the next generation; however, the tax consequences can vary by individual and by company. As a result, the parties involved in a family business transfer need to be proactive in understanding their options and the potential impact.
If you have questions about how to best transfer ownership of your family business, please explore our Transition & Exit Planning Services or contact us. We are always happy to consult with you and determine which path best meets the needs of you and your family.