For many business owners, their retirement will be coupled with the passing of their business onto the next generation. This sounds like it would be a straightforward procedure: a private transaction between a parent (i.e. the owner) and their children. Unfortunately, transferring ownership of a business—regardless if it’s parent-to-child or an external transaction—can be a lengthy and complicated process.
For one, the details of the transfer will depend on the business structure. Technically, business owners cannot transfer ownership unless their business is properly formed (meaning it is a state-registered LLC or Corporation). Unincorporated structures like sole proprietorships can’t really be bought or sold, as they aren’t legal entities – although assets such as key contracts or intellectual property can be transferred in certain circumstances.
Another point to consider is the ownership structure. If there is one sole owner, ownership in its entirety can be transferred to another individual. But if ownership is distributed among multiple shareholders, then only the shares can be transferred. In both instances, the transaction will be heavily taxed if not handled carefully.
The end-goal should be an efficient and fair transfer that clearly defines the ownership of all parties and minimizes the overall tax burden. However—as many business owners find-out—running a business is different than selling a business, and successfully executing such a transaction is easier said than done.
Estate taxes are an incredibly important consideration when passing a business onto a child. Exactly how much is taxed depends on a number of factors; chief among them is how the ownership is transferred. Generally, there are three ways to transfer ownership (ownership being either company shares or the business itself) to a child:
Partial Sale of the Business
In a partial sale, the owner will retain some of the business equity. This allows owners to remain involved and provides a level of flexibility for both parties. It’s also useful if owners aren’t fully ready to step-away from the business, as it ensures a steady income as well as a smooth transition of ownership. Partial sales are very common, and oftentimes make more financial sense than selling the business outright.
Outright Sale of the Business
Business assets or shares can be sold outright as well. These typically get expensive, and the family member planning to purchase the business may not have the cash for the transaction. In these situations, the owners can finance the deal, and the incoming owners can make payments in exchange for increasing ownership in the company.
Gifting the Business
Instead of selling, business shares/assets can be gifted from owners to recipients. Gifting is when property is transferred for free or less than its fair market value. Perhaps unsurprisingly, gifts are still taxed by the federal government, albeit to a much lesser extent than a traditional transaction. In 2019, the annual gift tax exemption is $15,000 per person, meaning that an individual can gift up to $15,000 to an unlimited number of individuals per year before the gifts are applied to the individual’s lifetime exemption. The lifetime exemption is the total amount of gifts that can be given over an individual’s lifetime before they are taxed; it’s currently set to $11.4 million per person. In these situations, it is the gift-giver that is taxed, not the recipient. This means that if the business is worth less than $11 million, it can perhaps be gifted without any tax burden at-all.
First things First, Determine your Own Financial Needs
It’s critical for owners to determine their own financial needs before selling their assets or business shares. This often requires an in-depth analysis of the business’s financial standing and a review of the owner’s personal accounts and financial goals. Parents that gift or undervalue their business may find themselves financially struggling 10- to 15-years down the road.
For this reason, it’s perhaps most common for parting-owners to retain some equity in their business instead of selling it outright. If the parent is the sole owner, they may opt to sell only a portion of the equity to their children. By doing so, they retain some stake in the business, but are far less responsible for the day-to-day. It also ensures a smooth transition for the incoming owner.
If the business has shared ownership (as is often the case with LLCs and Corporations), owners can transfer some of their company shares to their children. This can be done gradually over-time to ensure a smooth transition of ownership. In some instances, owners elect to retain their board seat, even though their stake in the company has reduced. Another option involves setting-up a family trust, where the share values are frozen, and the trust continues to buy new shares at a low-value amount. Any family member can be designated as a beneficiary and will receive their pay-outs accordingly.
Regardless of how much the owner wishes to remain involved, one thing should be given serious consideration: the minimization of taxes. The tax burden associated with transferring business ownership largely depends on exactly how the transaction is executed, which ultimately depends on your specific situation.