According to the Conway Center for Family Business, approximately 30% of family-owned businesses make the transition to the second generation. If you are considering transferring the ownership of your business (Selling your business) to a family member, it is important to have a comprehensive succession plan in place.
You may need the services of a business lawyer or other skilled professionals to determine how to transfer ownership of the business to a family member, especially if that member is a child so that you incur the least amount of debt and tax liability possible.
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The Family Member Transfer (Selling your business)
There are a few different avenues that you can take to transfer the business to a member of your family, and a primary motivation for this strategy is to avoid estate taxes.
As an owner, you can transition a business over time while you are alive by selling, bonusing, or gifting shares of stock to a family member or members on an annual basis. The shares are usually small interests in the company, and the current owner maintains control of the business during the initial transfer. The owner holds on to a majority interest (greater than 50%) of the voting shares during this time period.
Who qualifies as a family member?
The IRS defines a family member as any of the following:
- Spouse
- Ancestors*
- Children
- Grandchildren
- Great Grandchildren
- Spouse of children
- A legally adopted child
Selling your business to a family member vs. selling to an employee
Following are some pros of selling the business to a family member:
- Selling to a family member may maximize the amount of money the owner receives
- The owner stays in control of the business until he or she receives all monies. This is taking into consideration that seller financing or some other type of arrangement was involved.
- The owner’s risk is minimized.
Depending on your situation, selling or transferring a business to an employee may work out better for you. However, keep in mind the cons of selling your business to an employee, such as:
- An employee may expect a lower selling price
- Making an unacceptable purchase offer
- Not securing adequate financing
Selling to a family member or an employee, the choice is totally up to you. Before you decide on whether you will sell or transfer to a family member or an employee, know what is involved from both perspectives. A business lawyer or other professionals such as the professionals at ExitGuide can assist you with this.
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What are the transfer options of a business to a family member?
There are 3 main ways a business can be transferred to a family member. The three ways are as follows:
- Gift
- Sale
- Partial Sale
Gifting the business to a member of your family
If you are looking to just get out from under the business because of debt and taxes owed, you may want to pass on the responsibility to a family member who has the time and energy to try to turn the business around. If you do that, you can gift the family member the business.
Gifting the business to a family member, you won’t make any money. However, you’ll likely be able to sleep better at night without having to worry about business matters anymore.
Taking into consideration the lifetime gift tax exemption amount, which, as of this writing (2022), is currently $12,060,000 million, you won’t have to worry about paying gift taxes, unless, of course, you have already reached the lifetime exemption amount.
Even if the business is profitable and in good standing, you may still want to gift the business to a family member. Maybe it has gotten to the point that it is time for you to retire, maybe you are dealing with health issues, or maybe there is no other reason other than just wanting to gift the business to a family; it is definitely doable.
If the business is valued at less than $12,060,000 million, you’re good to go, and you can gift the business away without having to pay gift taxes. The lifetime gift tax exclusion amount increased from $11,700,000 in 2021 to the current $12,060,000 amount.
While you can gift only part of the business away if you want to, keep in mind that just gifting part of the business away, you will have some liability relating to capital gains and estate taxes.
Selling your business to a member of the family
Another option is to sell your business to a family member, either in full or partially. If the family member does not have all of the funds upfront to purchase the business, consider the seller financing the majority of the sales price for them. The family member could try going to a bank for an SBA loan.
Most banks do not like to make loans to people to purchase an existing business unless the person has an excellent commercial credit history.
However, as the majority of an SBA loan is backed by the government, the family member may have a better chance of securing a loan from the bank, providing that all necessary requirements are met.
If you decide to go the seller financing route, you will have to conduct a note sale where the family member agrees to make payments to you every month in exchange for getting ownership of the company.
The monthly payments are applied to the principal amount that was seller-financed with added interest on top of it. If the buyer defaults, you would legally be able to get the business back and you can keep all the payments that were made up until that point.
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A partial sale of the business to a family member
The third option is that you can conduct a partial sale. With a partial sale, you only transfer certain portions of your business and its assets. Conducting a partial sale allows you the flexibility to still have some say in how the company is run and allows you to continue to receive a steady income from leasing the assets and building to the new owner.
The downside of a partial sale is that your profits from the partial sale will be subjected to capital gains tax. This is true for the sale of any business with a profit. There is an upside to a partial sale, which is that you can cash out and still continue to receive a steady income at the same time.
Minimizing Taxes
So what if the value of the business is more than the current year’s lifetime gift tax exemption amount, which for the tax year 2022 is $12,060,000? In this case, the owner can take advantage of the annual gift tax exclusion amount, which is currently $16,000.
This means that you can gift up to $16,000 per year to one or more individuals and not have to pay gift taxes. The $16,000 can be counted towards any portion of your business that your gift to a family member.
One way of taking advantage of the annual exclusion amount is to create a systematic gift-giving program with your family member or members for the purpose of gifting business interests to them without incurring much gift tax liability.
You could gift $16,000, or whatever the annual gift tax exclusion amount is for the year to the family member or member’s peer year until the business interests have all been transferred.
Systematic gifting allows you to transfer large portions of your business without having any gift tax liability. The downside to systematic gifting is that you will have to wait a number of years before the transfer of the business is complete.
If you just want to transfer a portion of the business, the systematic approach maybe your best option. Refer to frequently asked questions for more detailed information relating to gift taxes.
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Final Thoughts
Whether gifting your business to a family member, an employee, or another outsider, it is important that you take into consideration the pros and cons of each scenario. You should also have well-thought-out plans as to how you want to make the exit from the business. It is wise to think about this matter well in advance, not when you are ready to make the exit from the business.