Transferring Your Company to a Business-Active Child
Choosing an Appropriate Transfer Technique to Meet Your Needs
Lao Tzu, the ancient Chinese philosopher, may not have been a closely held business owner, but he had it right, 2,500 years ago, when he said that “A journey of a thousand miles must begin with a single step.” Many family business owners face such a journey – a journey that begins with the decision to transfer the business to children and ends only when the final ownership interest is transferred.
So, when you decide to transfer your ownership to a business-active child, which exit path should you follow? Fortunately, there are a variety of options available to meet each business owner’s unique needs. The following series of the Exit Planning Navigator® articles will compare three of the most common business-active child transfer techniques – gifting ownership, selling ownership and transferring ownership via a stock bonus.
Choosing the most appropriate technique begins with establishing your overall ownership transition objectives – this is the real starting point for any kind of owner-based Exit Planning. In Exit Planning, it is critical for business owners to identify their objectives and resources before proceeding with the Exit Planning Process.
The resources available to you may include the current value of your business, the projected future cash flow (excess profit) that your business is likely to generate, and the base value and likely income stream generated by your non-business assets. A successful plan design should use these available resources to satisfy your financial requirements and objectives of not only transferring a business interest to a child, but also helping to ensure your financial security during and after the ownership transfers to the business-active child.
To determine your exit objectives, you should answer the following questions:
If you wish to transfer your business to an employee or to a child, you also should review the following questions:
The answers to these questions provide the basis for determining which transfer technique is most appropriate for your specific situation – whether it’s gifting ownership, selling ownership or transferring ownership via a stock bonus. Each transfer method typically has different tax and other consequences.
To best illustrate each type of transfer method, we will look at the case study of business owner Ted Stevens and his business-active Child Sharon O’Meara throughout this series of articles.
When Ted Stevens approached his advisor about transferring his $5 million S corporation to his business-active child, Sharon O’Meara, he told his advisor that he wished to transfer 20 percent of his ownership to Sharon as soon as possible and he did not need any money from this initial transfer of ownership. Ted’s business had a free cash flow of $1 million per year. (It’s important to note that “free cash flow” refers only to the profit of the business that is available for use in planning i.e., does not have to be retained by the business or used to fund future growth, so it is usually distributed to the shareholders in the form of S distribution.) Ted’s business was somewhat mature and stable, so in his case all of the profit of the business was able to be distributed to owners.
A valuation specialist determined that the value of 20 percent of Ted’s business, after using appropriate discounting techniques, was $650,000. The company’s owners expect an ordinary income tax rate of 40 percent, a capital gains tax rate of 20 percent (15 percent federal and 5 percent state) and the gift tax rate if 45 percent.
After gathering the details of the business and assessing Ted’s objectives, his advisor reviewed Ted’s transfer options with him, which included a stock sale, a transfer using a gift or stock bonus. In the next Exit Planning Navigator® articles, we will look at the specifics of each of these transfer techniques and how you may use them to meet your overall business transfer objectives.
If you have any questions about transferring your company to a business-active child, please contact Kevin Short, Managing Director (firstname.lastname@example.org).
Subsequent issues of The Exit Planning Navigator® discuss all aspects of Exit Planning. If you have questions, please contact Kevin Short, Managing Director (email@example.com).
1 Feldman, Dr. Stanley J. and Winsby, Roger, “Financial Service Needs of Established Business Owners: The Size and Demographics of a Wealthy Underserved Market,” Axiom Valuation Solutions, formerly bizownerHQ.
2 Canadian Federation of Independent Business (CFIB), “Is Your Business Worth What You Think It Is?” Deloitte & Touche LLP - Canada (English), Posted June 25, 2006.
3 Pricewaterhouse Coopers, “Trendsetter Barometer,” released January 31, 2005.
4 The Wall Street Journal, “The Retirement Lies We Tell Ourselves,” December 11, 2006.