The epitome of the American dream is to be a family-oriented entrepreneur who has created a successful business. Your company is not only a source of pride, but also the basis for your wealth in retirement and a legacy to leave your family.
There is often a wrinkle in this dream that occurs when you exit your business. And yes, you will eventually exit your business, whether after a retirement party … or in a gurney. The wrinkle is that unanticipated federal and state taxes can make your exit messy and even wipe out your business’s equity. Key to a preventative planning process is to secure good professional advice, and to use caution in exiting. Otherwise your dream may morph into a nightmare.
Tax Challenges at Exit
If your goal is to keep your business in the family when you exit, you can distribute your business ownership in four basic ways.
– Gift the business to your family when you retire
– Bequeath the business at death
– Sell your stock to your family (during life or at death)
– Sell your stock back to your family business (during life or at death)
Each of these exit strategies has its own tax challenges.
Gifting your interest in the business. Gifting stock in your business to family members has many non-tax issues, such as the inequality created between those who are and are not in the family business, future conflicts over managing the business, and – because your children received versus earned their ownership – possibly removing the motivation for them to succeed. But perhaps the biggest issue is that gifting your stock means you will not have an “equity event”. In other words, the business can no longer support your income needs through compensation or dividends, and you can’t tap your equity because you’re gifting rather than selling your stock.
These issues alone are vexing, but there are tax implications as well. At the federal level, there is the potential for a 40% gift tax payable by you as donor of the stock. Some states also impose a gift tax. Further, in some states, you may be subject to capital gains tax on the appreciation of the stock at the time of transfer. A tax challenge for the family is that your income tax basis in the business carries over to the donees of the gift, i.e. your family. If they ever decide to sell the gifted stock, they may face significant capital gains.
Leaving the business to your family at death. There are myriad problems with waiting until death to leave your stock to the family. Assuming that at some point you’ll retire, a concern is that even though you own the business, you’re subjecting your retirement income to the success or failure of others who are managing your business. And, at the same time, you are disincentivizing your children by denying them a current equity stake in the company. There are tax concerns as well. While bequeathing your stock to the family allows for a step-up in the stock’s income tax basis, it also means the lifetime appreciation in your stock may compound your exposure to the 40% federal estate tax. This exposure is exacerbated by the fact that the federal exemption for estate taxes will be cut in half starting in 2026. Even if your business wealth does not put you in the range of estate taxes, income taxes are a significant threat. Particularly if proper planning didn’t occur during your lifetime, in order for your estate to generate sufficient liquidity the business will need to redeem your stock. The estate receives cash, and the business retires your shares. Although usually these sales of stock result in a capital gains tax, and then only to the extent of appreciation after death, this is often not the case with family businesses. The redemption of stock in a family-owned business can result in the transaction being treated as a dividend rather than a sale. Since there is no step-up in basis in this case, the income tax bill can be significant and pose a threat to the liquidity of the family and the business.
Selling the business to your family. A buy-sell agreement with your children can be created that includes a sale upon your disability, retirement or death. Non-tax reasons for a buy-sell agreement include the market it creates for your stock, the diversification and liquidity it gives you as the seller, and the incentive it provides to your successors to succeed. From a tax standpoint, if your children are the buyers during your lifetime, they will obtain a new income tax basis in the stock. But there is a challenge for you as a seller. If you sell to your children during lifetime for a lump sum, you pay capital gain on the appreciation of your business above your cost basis. So even though the sale is meant to generate an income for your retirement, your tax bill is payable upfront.
The reality for most family businesses is that the children will not have the necessary wealth to buy you out in a lump sum. Instead, they will take on an installment note payable to you over a number of years. While this can spread out your capital gains taxes, it also means your largest source of retirement capital – your business – will be subject to the successes and failures of your children as business owners. If they fail, payments of the installments may cease, and a key source of your retirement income is in jeopardy.
If the sale to the family occurs at your death, the challenges may not be as dire from a tax perspective. Life insurance can be purchased on your life, so that your family has the needed liquidity to buy the stock from your estate. Plus, the buyers will obtain an increase in their tax basis.
Selling your stock back to your business. Adult children in family businesses are often not in a financial position to purchase the business owner’s stock. Accordingly, many family businesses structure the owner’s exit as a redemption of the owner’s stock by the company. The company will have more access to cash to make payments, and it may be a better credit risk than the owner’s children. As mentioned above, a stock redemption plan opens a veritable can of tax worms with family-owned businesses. In many cases the redemption distribution is taxed as a dividend rather than a capital gains transaction.
In order to avoid this outcome with a lifetime redemption of your stock, you may have to agree to completely remove yourself from the business. Not only removing yourself as an owner, but the tax provision requires that the parent may not retain an interest as an “officer, director or employee.” This has the potential to make you a creditor to the company without having any say in the company’s management.
A more recent, and threatening, tax issue involves situations where the owner’s stock is redeemed at death. Typically, a deathtime redemption is financed by the company owning life insurance on the business owner’s life. When the owner dies, the company collects the death benefit and uses it to redeem stock from the estate. A case this year surprised many advisors by including the life insurance death proceeds in the valuation of the business for the gross estate of the deceased owner. For example, if your stock is worth $3 million, and the business has a $3 million life insurance policy on your life, at your death your estate could be paying a 40% estate tax on a business valued closer to $6 million than $3 million. For those who are wealthy enough to be subject to the estate tax, this outcome would significantly increase the costs of exiting your business.
All Is Not Lost
There are numerous ways, from both a legal and financial perspective, that these troubling issues can be planned for. As a business entrepreneur you can still retire and keep your business in the family. But it’s not a simple process, and it takes expert advice. If you want to successfully leave the family business as a legacy, below is a list of steps to consider in doing your exit planning.
– Obtain a business valuation or appraisal of your business. You really can’t assess the tax costs of your departure until you have quantified the size of the issue. And remember: the IRS may have a different opinion than yours of the company’s value.
– Get competent legal advice. Each business entity type has its own issues, and there are multiple gift and sales strategies that can be deployed to save taxes. The professional advice you obtain should include expertise in both tax and business law.
– Address funding. Depending on when you plan to exit your business, you’ll need appropriate funding. This may involve bank financing, a sinking fund during life, and/or life insurance to address a distribution at death. How this funding is structured can have a significant impact on the overall taxation of your exit plan.
– Include your business planning as part of your retirement planning. Assuming your business represents a major portion of your retirement capital, you’ll need to address how to transform an illiquid, non-diversified asset (your business) into a predictable retirement stream (an income you can’t outlive).
– Involve your family in the planning. Tax and legal plans can quickly fall apart when the family isn’t bought into the plan. If leaving your successful business to future generations is part of your legacy plan, your family deserves to know the details.
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