Business Transition

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A big portion of your retirement plan is probably dependent on selling your business. With a carefully crafted business transition plan, you can help meet your retirement goals and successfully transfer your business. Even if you are not depending on your business for retirement, you may be planning for the ultimate transition it to family members.

A business transition plan may include a buy-sell agreement with your co-owners that outlines the terms of the sale, including triggering events and how and when the sale price will be paid. If you plan to have family members take over the business, the buy-sell agreement should be a “bona fide” agreement. In all family transfer situations, a professional valuation or appraisal is highly recommended to establish an independent fair market value of the business.

If you are going to sell your business interest at retirement you may be concerned about:

  • Determining how and when the purchase price will be paid.
  • Minimizing tax consequences.
  • Improving the creditworthiness of the business.
  • Leaving the business in good financial shape for the future owners.
  • Being sure the purchaser will have the funds to complete the buy-out.

If your plan is for family members to take over the business, you may also be wondering:

  • How long do I stay on for a successful transition?
  • Are they familiar enough with the business and ready to take over management?
  • What about my children who are not involved in the business?

Sales between family members are often subject to more scrutiny by the IRS. More specifically, the IRS may question the sale price or valuation method used. If the price is determined to be higher or lower than “fair market value,” the sale may be re-characterized as a part sale, part gift transaction, resulting in potential gift tax liability or inclusion of a portion of the sale price in the seller’s gross estate.

Visit our Frequently Asked Questions.

If you have established an agreement between yourself and your co-owners, one major concern is to be sure the purchaser will have the funds to complete the buy-out.

There are a number of ways to fund a buy-out at retirement (there are different concerns for a buy-out triggered at death or disability).

When there is time to plan, the use of a Sinking Fund (some of us call this a savings account) can be a way to accumulate money for the ultimate buy-out.

A Sinking Fund is when the buyer sets dollars aside to accumulate to the purchase price in advance of the sale. These funds are often held in an interest-bearing account and, depending on the time frame, the sinking fund may or may not have accumulated the funds needed by the time the purchase takes place.

If the party interested in purchasing your business doesn’t have the cash available to fund a lump sum purchase, they may be able to borrow funds from a lender to complete the purchase. There are challenges to borrowing funds from a third party lender – you don’t know what the interest rate will be at the time retirement occurs, it’s impossible to know whether the lenders will make the loan to you, and finally, will the business be able to absorb the new debt and continue to be a viable business entity?

A classic method is to pay the purchase price over time in the form of an installment buy out An added benefit of allowing the purchase to be spread over time allows you to spread any gain on the sale over the payment period.

An installment sale is a “seller-financed,” deferred-payment financing arrangement.

The buyer gives the seller a promissory note and then makes payments towards the purchase price over two or more years. The parties to the agreement have a significant amount of flexibility in determining the terms of the note, including the interest rate, the amount of each payment or the duration of the note.

Payment can even be deferred until after retirement when the seller may be in a lower income tax bracket. The buyer must continue to make payments of principal and interest to the seller or the seller’s estate until the full price is paid.

Ownership of the business passes to the buyer immediately when the installment note is executed. This can serve to “freeze the value of the business” – any subsequent appreciation for the business is removed from the seller’s estate. Should the seller’s death occur before all payments are received, only the balance due on the note is included in the value of their estate.

The benefits of gifting a business to family members are two-fold.

First, gifting lets you shift the business interests to those of your choice. You control both the timing and the size of the gifts.

Second, gifting can reduce the value of your interest in the business, both for purposes of future estate tax liability or a future sale. Valuation discounts may be used to further reduce the value of the transfers.

There are several ways to make gifts:

Annual Exclusion Gifts

An annual gifting program of business interests provides a way to systematically reduce your business interest over a period of years.

Gifts up to the annual limit can be made to an unlimited number of beneficiaries each calendar year. A married donor can take advantage of “gift splitting.” This allows one spouse to transfer twice as much, even if all of the assets being transferred are owned by one spouse. However, depending on the size of the business, the number of intended recipients and the age of the business owner, the time frame during which to transfer the business using only the annual exclusion amount may not be sufficient.

Lifetime Transfer Tax Exemption

Each individual has a lifetime transfer tax exemption amount. You may want to consider making a gift up to this amount during your lifetime, rather than upon death, to remove potential appreciation of the business interest from your estate now.

This could result in a significant estate tax savings, especially if the value of the business is expected to increase substantially over time.

Gift Savings Devices

When you use the annual exclusion or lifetime exemption amounts, the asset being transferred must be valued. It may be possible to use certain techniques that allow you to take certain discounts, effectively letting you transfer more of the business while staying within the limits of the annual exclusion and lifetime exemption amounts.

One of these techniques is the use of a family limited partnership. A business interest can be transferred using another entity, such as a Family Limited Partnership (FLP).

With an FLP, you transfer part or all of your business interest to an FLP in return for general and limited partnership interest. You may retain the general partnership interest (at least for a period of time), retaining control of the business and receiving an income, and then gift some or all of the limited partnership interest to your family (either outright or in trust).

Bequest or Transfers at Death

Instead of gifting the business during life, you may want to transfer the business at death.

To ensure that the business is actually distributed to the people you want it transferred to, a valid will or trust should be in place. The absence of a will or a trust could result in the business being split among your heirs, including people who may have no interest in owning the business.

While this strategy will allow you to retain control of the business for as long as possible, and provides a stepped up basis for the recipient(s), there are drawbacks. The value of the business will be included in your gross estate, which,depending on the value of your other assets could result in an estate tax liability.

Estate Equalization using life insurance can help ensure all of your heirs are treated fairly and equitably.

If your plan is to transfer your business to family members, leaving equal shares of the business to family members actively involved in the business as well as those who are not can often cause conflict. Leaving the business to only the participating family members can also cause conflict within the family.

So, what to do? One option to keep peace within the family is to leave non-business assets to non-participating family members to equalize the distribution of your estate.

Another option is to purchase a life insurance policy to help achieve an equitable transfer of your estate. You can leave your business to family members involved in the business and use the life insurance proceeds to provide an inheritance for other family members.

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