Succession Planning: Tax Considerations When Exiting Your BusinessBy Dannell R. Lyne | February 11, 2020
There comes a time when business owners begin to contemplate retirement and an exit from the company they own and/or are operating. This is when succession planning should begin. For those in larger companies, it may be easier to identify talent already within the company to take the reins. However, this may not be the case for those who are in smaller, closely-held businesses or who are sole owners. For these types of owners, in addition to determining how to pass on their business, they must understand the tax ramifications of transitioning the business. This article will discuss a few exit strategies and the tax consequences to consider.
SELL AND EXIT APPROACH
Some owners would prefer to sell and immediately exit the business. This would be the case when selling to another company that is knowledgeable about that industry or to a member of management, an approach that would ensure a smooth and seamless transition. Realizing the tax treatment from a sale like this will depend on several factors. In some cases, the seller may decide to take a lump-sum payment, and the sale will generate long-term capital gain taxes at 20% on the federal level. However, if a business contains hot assets (ordinary income-producing assets, such as accounts receivable and inventory) as part of the sale, then an ordinary gain would have to be bifurcated from the long-term capital gain and taxed at ordinary rates up to 37%. This can occur in the year of the sale or over a period of time, usually three to five years.
Another option when exiting a business would be to stay on during a transition period. Typically, this period lasts from one to three years and gives new owners time to understand and know their new customers/ clients and vice versa. The exiting owner could be paid as a consultant during this transitionary period, which would yield ordinary income, and then initiate the buyout agreement, which would yield long-term capital gains after the transition period.
Yet another alternative would be a combined payment of the consulting and buyout agreements. The exiting owner would recognize ordinary and long-term capital gain income during the transition period and longterm capital gains during the buyout period once the transition period ends (provided there are no assets that would lead to a recognition of ordinary income as a part of the sale).
Also, consider how the business is going to be sold. Will the seller sell only the assets of the company, while keeping the company in existence from a legal standpoint and subsequently dissolve at a later date? Will the exit be a sale of ownership interest (e.g., stock, partnership interest, LLC units)?
Depending on the structure of the business, most sales will result in a taxable event. However, owners of businesses held as corporations may be able to have the gain on the sale excluded. If an individual owns qualified small business stock (QSBS) (i.e., stock received by the taxpayer at its original issue) and has held on to it for at least five years, 100% of the gain can be excluded. The 100% exclusion applies to QSBS acquired after September 27, 2010. QSBS acquired before will be subjected to an exclusion of 75% (acquired between February 17, 2009 and September 27, 2010) or 50% (acquired before February 18, 2009), so please keep this in mind when considering this as a part of your planning.
In conclusion, these are just a few items from a tax point of view to consider when engaging in succession planning. Speaking with your tax advisor will help you determine the most effective and beneficial ways to prepare.
About Dannell R. Lyne
Dannell R. Lyne, CPA, MST, is a Partner in the Private Client Services Group at Marks Paneth LLP. To this role, he brings extensive experience in tax planning and compliance for family owned businesses, nonprofit organizations, alternative investment funds and high-net-worth individuals – specifically executives in the financial services industry, investment partnerships and international matters. Prior to joining Marks Paneth, Mr. Lyne was a Partner with Dylewsky, Goldberg & Brenner, LLC – a Connecticut-based, full service... READ MORE +