Count yourself lucky. It’s a pretty rare thing indeed when your kids have an interest in your business, and even more so when they have the desire to take the reins and assume responsibility for the whole operation.
Doubtless you’ve been grooming your son or daughter from the ground up. Teaching them all aspects from the menial maintenance chores to the secret intangible sauce that makes your business win and retain customers.
Transitioning your business to within your family can be one of the best ways to sell your business. Why? Because -
- you can structure a transaction that can pay you a stream of income and essentially fund your retirement;
- it will allow you options as to how much you continue to work or provide essential guidance and intangible knowledge (which is often the secret ingredient for success); and,
- you’ll get tremendous satisfaction by setting up your son or daughter to earn their legacy with the business you created.
The primary focus of this post are the alternative structures of the financial deal between you and your successor. The tough trick will be how you can extract value from the deal to meet your needs in retirement without putting excessive pressure on the business. Obviously you want your son or daughter to be hugely successful – to earn as good a living as you have.
One issue than can complicate any family business succession is how best to treat other family members that do not wish to take an active role in the business. This is a very important issue, but for the sake of simplicity, it will have to be dealt with in a future blog post.
For purposes of this discussion, I assume that you have a current valuation of the company, hopefully prepared with the assistance of a business broker, a CPA and possibly a certified business appraiser.
Purchase a legal ownership interest. The majority of the businesses we see are either an S Corporation or a limited liability company (LLC). Both of these legal forms have many beneficial characteristics for private businesses. Nevertheless, any transfer of ownership between people must be legally documented with the state of organization and also on income tax returns.
Sale or issuance of shares in an S Corporation is pretty simple, which is one of the best benefits of this entity type. A new interest in an LLC is a bit less clear, but can be quite simple as well. Both acquisitions can be accomplished as a direct transaction between owners, or as a transaction with the existing legal entity. Be sure you understand the tax ramifications of each alternative – they differ drastically!
Also, keep in mind that it will be necessary to allocate the activity for the tax year to properly share and report the taxable income or loss to each owner at tax time.
A Few Alternatives
Parent Funded – This approach has a number of positives in that it can be simple and inexpensive to put in place. An installment agreement will also spread any tax gains over the multiple years of repayment. The payments of principal and interest will provide a stream of retirement income and the terms can be set to ensure business cash flows are not crippled. This alternative may not be feasible when you need to liquidate a liability, or otherwise need a large upfront cash payment at the time of the transaction.
Bank Borrowing – You’ve likely developed good banking relationships over the years. A banker that knows you and your business, and also knows your successor, may be willing to fund most of the transaction. Conventional lending has been very hard for obtain for all business owners over the last few years, but it may be available as part of a larger acquisition funding plan in which only a portion of the repayment plan requires borrowed funds.
SBA Funding – About the only bright spot we’ve seen in the capital markets over the past few years has been a more streamlined focus on small business needs by the SBA. The SBA exists to support businesses that create jobs. The SBA will lend to a child wishing to succeed a parent in a business. They do have a couple of rules that must be clearly understood: 1) the child successor must acquire 100% of the business, and 2) the parent must not be employed or remain active in the business after the transaction. Ouch. I suppose these rules stem from past abuse of SBA lending. If you can work with these demands, SBA lending is a very good way to go.
Segregate Real Estate – It may be possible to hold or transfer any real property, facilities and improvements into a separate entity from the operating business. In this way, you will continue to own the real estate portion and earn income through a lease on the facilities. This might be your primary source of retirement income. This should result in a lower acquisition value of the business assets and thus it may be easier for your successor to handle the purchase of the stock or member interest.
This approach also allows you to postpone the purchase of the real estate to a future period, and it may also fit nicely with your overall estate planning.
Key Man Life Insurance – Under this approach, you might issue one share in the S Corporation to your son or daughter, with you retaining the rest of the ownership interest. The child assumes operational control and earns an appropriate salary for doing so. You continue to earn an annual stream of income from the business, which essentially becomes your retirement.
You can continue to share in the operations, but scale back the hours. Focus on your best customers!
A life insurance policy is purchased that will cover most of a predetermined stock purchase transaction upon the event of your death. If the insurance policy does not quite cover the acquisition price, your agreement provides for a note for the remainder to be paid either to your surviving spouse or to your estate.
The acquisition transaction can be effected either through a stock redemption, so that your child is the only remaining shareholder, or it could be an outside transaction between your surviving spouse or your estate. If properly structured, there can be some tremendous tax efficiencies to this approach.
Most key man policies are term policies, and if you’re in good health, the premiums can be fairly reasonable. Don’t ignore the use of a whole life policy for this approach. We have seen them used effectively, both owned by the business entity itself, or owned by the acquiring successor personally. Tax advisors get pretty worked up about the lack of a tax deduction for company owned life insurance, but when considered economically, the benefits to a whole life policy can outweigh the loss of a tax deduction. If fact, the cash surrender value may seriously strengthen your balance sheet in the eyes of a lender.
We’ve just briefly whipped through some very different alternatives, haven’t we? One thing is certain – if your kid wants to take over your business, we can find some combination of planning ideas to get it done.