One of the more difficult estate planning problems is transferring a small business in a way that maximizes after-tax value. Unfortunately, many business owners don’t handle the transition well. Planning for a small business transition should begin at least five years before the transition might occur.
You should take the key steps that make a business more attractive to potential buyers. The business systems need to be much tighter than they are in most small businesses. A potential buyer wants reliable and comprehensive data. The accounting data is the most important to most buyers. But data analysis of all aspects of a business is a major tool these days. You might need to upgrade your systems to provide detailed data about all facets of sales, production, marketing and other functions.
You also want to convince buyers the business isn’t dependent on one person. Many small businesses are reliant on their founders and owners. To maximize the value, build a team of people who are responsible for different functions. A buyer will pay more for a quality workforce with low turnover that’s likely to remain when ownership changes. You want a diversified revenue base.
A buyer will be hesitant to purchase a company that relies on a small number of customers or products, especially when sales are dependent on a personal connection with the owner. You also want to focus on growth. Many buyers won’t pay top dollar for a firm with stagnant revenue, even if it’s making a healthy profit.
Make your business all about business. Many small businesses often have some overlap between the owner’s personal and family interests. There might be family members on the payroll who are being paid more than they would receive at other firms. Whenever possible, personal expenses are run through the business. That’s all smart when you plan to keep the business indefinitely.
But as you prepare to sell, phase out the personal and family subsidies. You’re likely to receive more by using a team of experts to help sell the business. One or more business valuation experts should help you determine a reasonable value. They should explain how they arrived at their values and the likely range of values outsiders will put on the business.
You’ll also want accountants and lawyers who specialize in small business transitions. Ideally, you have tax and non-tax specialists, though some advisers are good at both angles. They’ll help implement the strategies already discussed and suggest others. When you select the right professionals, their advice will more than pay for their fees.
Finally, consider how to structure the transaction to maximize your after-tax value. There are many options. Begin reviewing them early in the process so you can substantially reduce the taxes. Too many business owners wait until a deal is reached and then start wondering how to reduce the taxes. By then, it’s often too late to take effective action.
Here are some key strategies to consider.
The charitable trust bailout. Before you conclude or even negotiate a sale, transfer the business to a charitable remainder trust. In the typical structure, the trust will pay you and your spouse income for as long as either is living. In most cases, the payout is either a percentage of the trust’s value at the beginning of the year or a fixed annual annuity.
After you and your spouse pass away, a charity or charities you designated will receive the property remaining in the trust. You receive a charitable contribution deduction when a property is transferred to the trust. The deduction is equal to the present value of the charity’s expected future gift. There are no capital gains taxes when the business is sold, because it will be owned by a charitable trust. The trust is free to invest all the sale proceeds to generate income for you.
A variation of the strategy is to separate the business into different segments. For example, the operations of the business might be one segment and the real estate from which it operates (if you own it) is another segment. You hold one segment in your name and sell. Transfer the other segment to a charitable remainder trust. The strategy has two advantages.
One advantage is you retain control of some of the sale proceeds.
The other advantage is that the charitable deduction from transferring a segment to the trust offsets some or all of the taxable gain from the sale of the other segment.
Employee stock ownership plan (ESOP). When you want to sell to current employees, an ESOP can be a good tool. There are many variations of the ESOP strategy, but here’s a standard one. A small business owner creates the ESOP. The company borrows money from a bank and, in turn, lends that money to the ESOP. The owner sells some or all of his stock to the ESOP.
Over time, the company makes annual contributions to the ESOP, which are deductible. The ESOP uses the money to repay the loan from the company, which the company uses to repay the loan from the bank. Special tax breaks allow the company to deduct both the interest and principal it pays on the loan. It also deducts contributions made to the ESOP, as well as any dividends it pays on company stock owned by the ESOP. The owner also gets tax breaks.
A gain from the sale of the stock to the ESOP is deferred if, within a year, the owner uses the proceeds to purchase securities issued by domestic companies and meets other restrictions. Taxes are due only as the owner sells those investments.
An ESOP is best for an owner who plans to sell to the employees and whose children don’t want to run or own the company. But it can work in other situations. There are a host of detailed rules for ESOPs. For example, all employees must be allowed ownership shares through the ESOP. Review the details with your advisors before making a decision.
Corporate redemption. This is a good strategy when you want to transfer the business to your children. Here’s how it worked in one case. A taxpayer owned 100% of a corporation. His adult children were directors, and he wanted them to take over both ownership and operation of the business. He gave some of his stock to the kids. The business redeemed the rest of his shares in exchange for an installment note.
The children now owned 100% of the outstanding stock, and he received regular payments from the company under the note. A stock redemption qualifies for long-term capital gain treatment when the selling shareholder terminates all his interest in the corporation, other than any interest as a creditor. Also, the gift of stock to the children can’t be primarily tax motivated.
The IRS said this particular transaction met all the requirements, so the owner paid long-term capital gains on the redemption of the stock. But do this type of transaction wrong, and the redemption will be treated as a dividend to either the children or to you. Those are examples of tax-wise strategies for selling a business. Talk with your advisers about different strategies early in the transition process to find the one that’s best for your goals and situation.