As explained below, there are multiple categories of people to whom the business owner may want to transfer the business, or the economic benefits of it.
An obvious first choice in many cases is to transfer the business to one’s family—usually the next generation. One drawback associated with transferring to one’s family, however, is that the transfer may be subject to estate or gift tax. Consequently, if the family does not have sufficient liquid assets to pay the corresponding tax bill, they might not even be able financially to make the transfer.
Fortunately, estate attorneys employ various methods to reduce or eliminate that tax liability. Some of these methods utilize a partnership or corporation to achieve a valuation discount from transferring partial interests in the entity. Alternatively, there is a funding mechanism option, usually involving the use of life insurance, so that there is sufficient liquidity to pay the resulting tax bill. Other methods exist, as well.
Family Limited Partnerships (FLP’s) are often used to facilitate a valuation discount, and also to provide other benefits to the family—like continuity of management and limited liability. Transferring a fractional interest of an entity is typically valued less than transferring a pro rata portion of the underlying assets in the entity. Thus, it is often more transfer tax effective to use one of these partnerships with the use of valuation discounts.
Caution must be used with these partnership techniques, however, when the valuation discount exceeds thirty percent (30%). When valuation discounts are in excess of the permitted amount (something that, in turn, is depended upon case law), it could lead to unanticipated gift or estate tax obligations. In the worst case, those tax liabilities will happen at a time when insufficient assets exist in the estate to pay the liability. Furthermore, discounts in excess of 30% often lead to an audit and transfers via interfamily sale can also result in retroactive revaluation.
Similar to the discounts achieved through partnerships, Grantor Retained Annuity Trusts (GRATs) can be utilized to facilitate a valuation discount. A GRAT involves the grantor retaining an annuity interest in the assets contributed to the trust, with a remainder interest being held in trust to benefit the grantor’s beneficiaries. The transferred amount (the amount of the gift) is the present value of the remainder interest, a fractional interest, and hence a valuation discount is allowed.
Common also is for a business owner to leave his employees a business interest. Often the family is not the best choice, either because they know nothing of the business, or lack the desire to continue in it. Thus, the owner desires to transfer the business to his or her employees.
The transfer can be to the employees in general, or to a limited group of people. And sometimes it can also be partly transferred to the employees, and partly to the family. Further, a transfer to employees may be a transfer of control or economic benefits or both. For example, voting shares of a company can be given to family members, and non-voting shares can be given to employees. In this sort of scenario, the owner gives the family control of the company, while passing on economic benefits to the employees.
Incentive stock option and nonqualified stock option plans can be used as mechanisms to keep younger successor employees in the business and continue to work towards building it during the business owner’s lifetime. Under these plans, employees can receive equity from the company (LLCs and partnerships) in the form of capital or profit interests.
Another common option is for the business owner to sell or transfer his or her interest in the business to the other existing co-owners. In this case, a buy-sell or shareholders agreement is an essential tool for succession. When an owner is departing from the company, or another triggering event occurs, the buy-sell agreement will set the valuation method and terms for purchasing that owner’s interest in the company. As explained elsewhere in much greater detail on this website, buy-sell agreements are important documents to have in place long before an owner thinks to transfer his business. As explained on this website, there are at least four problems a buy-sell agreement seeks to solve.
Rather than transferring a business to family, the employees, or to other existing owners, the exiting owner may decide to sell his interest to a third party buyer, who could either continue on the business or liquidate it. Rarely do outside buyers seek to acquire the stock of a business because of unknown off balance sheet business liabilities (like pending lawsuits and everyday product liability, for example).
For this reason most business sales are classified as “asset sales.” An earn-out agreement can be used to partially or fully finance an asset sale where the owner receives a deferred payment based on a formula that is linked to the company’s future sales performance or profitability. To keep the talent happy, retention bonuses can be used to retain key employees. The hope is that keeping on those key employees with the business will enhance the company’s value to the purchaser, while compensating the key employees for their loyalty to the original owner.
Less common is for a business owner to transfer his or her business interest to charity—either a charitable entity (like a foundation or a 501(c)(3) organization), or to a charitable trust (like a Charitable Remainder Trust).
A business owner may decide to charitably bequest his business assets if his family is already well off financially. The donation will, of course, help the charity advance its charitable purpose. But a transfer to the charity may be a good idea for another reason as well: Unlike the business owner or his family, a charitable trust can usually sell the interest without having to recognize tax (it is a tax-exempt entity). The proceeds can then benefit the family with an income or annuity interest, with the remaining trust corpus going to the charity at the death of the settlor (party(s) funding the trust). Thus, if may be advisable for an owner of a business in which he has a low income tax basis to transfer the appreciated assets to charity. This way the owner avoids the capital gains tax on the asset. Furthermore, the owner can receive an income tax deduction for the present value of the remainder interest, so there is usually an income tax benefit, as well.