4 Key Exit Considerations When Transferring to Insiders

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By Jennifer Mailhes Managing Director

Preparing the transition of your business can create different exit planning roadmaps depending on the state of your business or who’s at your final destination. Will it be a key member(s) of your management team or will you be succeeded by family? Regardless of your path, the main driver to make the transaction successful is beginning the planning process early to ensure the transition is clearly defined and properly communicated to all parties involved.

When exploring options to transfer the ownership of your business internally, consider these four key factors:

1. Determine Transfer Type: Are you transferring to a key employee or family member? There are different transfer structures to consider based on who’s taking ownership, such as:

Key Employee: If transitioning to a key member of your management team, do you want them to buy into the business or buy out the exiting owner(s)? Weigh the pros and cons of the transfer structure to help determine whether offering a direct ownership interest or initially providing stock options is most ideal. Based on your timeline, an additional option could be the employee purchasing the remaining stock or remaining owner interest once you’re ready to exit. Consider these client scenarios:

Owner buy-in: Owner had a buy/sell agreement but it was not aligned with his long-term business objectives. Once his objectives were defined, the buy/sell agreement was revised to allow two key employees to buy into the company, but also offer a buy-in option for his children in the future.

Stock ownership: One owner is in late 50s wanted to give a percentage of ownership to a key manager. The key manager was initially given 15 percent ownership, with the idea that he’ll pay it off and buy more ownership over time after the initial purchase is paid.

As you can see, each transfer can be strategically executed in a variety of ways.

Children:  The key consideration when transferring your business to children is creating a succession strategy that it does not create a future problem. A common situation I’ve seen far too many times is where one child is actively involved in running the business, but there are other children who own a significant portion and have little to no involvement – sometimes triggering a division in the family and a stagnant business.

The most optimal planning focuses on giving ownership based on earning it versus birthright, but balancing the desire to be fair to all heirs. A couple strategic alternatives to consider when transferring ownership include issuing it to the generation in the form of nonvoting stock or establishing different ownership in non-business assets.

There are other factors to consider such as how much ownership should be transferred initially, distribution of assets, tax strategies and more.

2. Create a Timeline – Regardless of who’s taking over the business, proactive planning is beneficial for both the owner(s) and successor(s). Ideally, the planning process should begin three to 10 years prior to the transition. Be sure to work with an advisor to develop a timeline, as they will help you establish exit objectives aligned with your timeline, offer recommendations based on the successor(s) and assist with facilitating the transition.

3. Financing Options: Work with your CPA or banker to determine whether the transfer needs to be financed, plus explore your financing options. Internal transfers are usually financed by the seller or the company. In most cases, the owner recognizes the business risk and likes a consistent rate of return on the seller note.

4. Explore Tax Strategies:  – The key question when transferring to insiders should be how to optimize the tax impact of the transaction to benefit both the successor(s) and owner(s). There are several tax planning strategies to consider based on the successor(s), such as:

Key Employee: If offering a direct ownership interest, be considerate of the future tax consequences that may come along with a buy-in deal. Transfers of ownership can be deemed as compensation to the employee. Stock options are also treated as compensation which may create tax consequences for both the owner(s) and employee.

Children:  The business interest can be sold to an intentionally defective grantor trust (IDGT) in exchange for a promissory note. No gain or loss is recognized on the sale and the grantor continues to pay tax on the IDGT’s share of the business income. The post transfer appreciation of the business passes to the beneficiaries free of estate tax. 

Working with a tax advisor like those at Doeren Mayhew CPAs and Advisors can help the seller outline their most favorable tax options and provide insight on how to maximize the transfer.

Alternatively, based on your business’ health and exit timeline, you could also explore selling to a third party or just liquidating the assets. Our M&A advisors work closely with middle-market businesses to evaluate their current business conditions and offer alternatives.

Understanding the ins and outs of internal transfers can be complex. Contact Doeren Mayhew Capital Advisors to help you navigate the process and guide you every step of the way.