3 options for transitioning your business.

Business founders3 options for transitioning your business

February 7, 2022

Key things to know

  • The process of transitioning out of a business can take three years or more, so it’s important to start planning well before retirement.

  • Options for transitioning your business include selling to a third party, transferring it to family members, or selling to your employees.

  • Your preferred approach should be aligned with your priorities and objectives.

It’s likely you spend most of your time focusing on the day-to-day aspects of running your business. As a result, you might not have put much thought into the importance of having a strategy in place for transitioning your ownership. Even if that event seems far into the future, it’s never too early to start thinking about what’s involved in the process.

“Business owners should plan for the eventual transition from their business the day they first set up the business,” says Romar Carl, director of wealth planning at Ascent Private Capital Management of U.S. Bank. “And they should run their business every day like it’s going to be transferred tomorrow. One day, you’ll transfer business operations even if you don’t want to.” The key is that with proper planning, you can choose the terms of the transfer and make sure it’s done in a tax-efficient manner.

This also means not waiting until retirement is just around the corner to begin thinking about what needs to get done to complete this process successfully. “As a rule of thumb, expect the entire process of transitioning out of the business to take three years, and sometimes longer,” says Eric Sanderson, senior managing director at Ascent Private Capital Management of U.S. Bank.

Three ways to transition a business

One step in preparing for a future business transition is to determine the method of transfer. There are three primary options to consider.

  • Selling the business to a third party
  • Transferring the business to family members
  • Selling it to employees of the organization

The method you identify as your preferred approach should be based on your own priorities in life. If you’re focused on generating the largest value for the business, you may put it on the market and seek the highest bidder among potential third-party buyers. If you intended that the business stay in the family, you’ll want to determine the best ways to execute a family transfer. If you feel your employees are in a strong position to take over operation of the business, selling it to an Employee Stock Option Plan (ESOP) is a consideration.

Option #1: Selling your business to a third-party buyer

There are different ways to approach putting your business on the market in search of an outside buyer. If you want to maximize the sale price with little regard to the “fit” or qualifications of the purchasing firm, you may want to put the business out for competitive bidding.

However, price may not be your only consideration. You may also be concerned about the quality of new management stepping in, how that will impact the legacy of the business you established and how the new management team might impact current employees. In this case, your focus turns to finding a buyer who represents a good cultural fit for the business.

“Business owners should plan for the eventual transition from their business the day they first set up the business. And they should run their business every day like it’s going to be transferred tomorrow.”

- Romar Carl, Ascent Private Capital Management

Before a transaction can be completed with a third-party buyer, they may request the opportunity to take a deeper dive into your company’s financial and legal records and even go so far as to talk to some of your customers. Buyers often have an accounting firm conduct a “quality of earnings” analysis to verify that the numbers being reported are accurate. Only after this is completed, in many scenarios, do final negotiations on a sale price get underway.

Option #2: Transferring to family members

If your business involves family members, particularly your children or grandchildren, you may want to shift ownership to one or more of them. There are a variety of strategies that can be used in making an intra-family transfer. Key to these is to try to manage the tax impact of the transaction. “If it’s a business of significant value, and if the owner dies before the business passes on to family heirs, an estate tax of 40% could apply,” says Sanderson. “Business owners who intend to see ownership passed on to other family members should consider doing so while they’re alive to minimize estate and income tax consequences.”

One option to consider is establishing a trust that generates a tax-advantageous transfer to beneficiaries. In addition to moving future appreciation out of your estate, your continuing income tax payments on the business’ income can further reduce your estate without incurring gift tax.

Owners of smaller companies can gift the business over a period of years, using the annual $16,000 gift tax exclusion to avoid tax consequences. Those with larger businesses who want to gift it to family members should consider doing so now, while the lifetime unified estate and gift tax exemption is at its highest ($12.06 million for individuals/$24.12 million for married couples filing jointly in 2022). Under current law, the exclusion amount will revert to approximately half that total in 2026.

“Liquidity is a big issue in transferring a business with value,” says Carl. “If the business passes at the owner’s death, the value is mostly wrapped up in the business and the beneficiaries owe a 40% estate tax on that amount beyond the exclusion.” In the event this occurs, life insurance should be in place to help provide liquidity to meet the estate tax burden.

Carl notes that gifts during a lifetime tend to offer an opportunity for greater tax efficiency. “If the owner makes gifts during their lifetime and pays any taxes due, that reduces the size of the owner’s estate. They avoid taxation of money that would be used to pay taxes on the estate at their death.”

Option #3: Selling your business to employees

While a less common form of business transfer, an employer stock option program (ESOP) may be appealing in situations where employees already play a key role in the operation and are in a position to assume leadership of the company once the owner departs.

An ESOP is a trust incorporated into an organization’s retirement plan. It offers tax advantages for the seller and for the ESOP as ultimate owner of the company. Employees who participate in an ESOP will be vested in the plan after a specific number of years, which encourages them to remain with the business over the long run.

“There are a lot of moving parts to an ESOP transaction, and it tends to be the best fit only in a very narrow set of circumstances,” says Sanderson. An ESOP often works most effectively for companies where the chief asset is human capital. That includes architectural, engineering and accounting firms.

Other key considerations when planning a business transition

The process of transferring a business involves a few other considerations, including:

  • Utilizing an outside firm to assess the value of the business before a transition occurs
  • How the business structure (C or S corporation, partnership, LLC) might impact the transfer process
  • Determining tax-efficient strategies when implementing the transfer
  • Communicating your plan to key players
  • Looking out for the best interests of customers and employees through the process

Allowing sufficient time for the process to unroll smoothly is critical. “It takes time to groom someone to assume leadership of the organization,” says Carl. While a three-year window to execute a transition is a “rule of thumb,” Carl notes that the situation is different for everybody, and in some cases, more time may be ideal. Therefore, getting a start on the process, even if the transition seems far into the future, is advisable.

Learn how Ascent Private Capital Management works with and supports business owners and founders through business transitions.

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