For many small business owners, being able to pass their business on to the next generation of their family is part of the American dream. All of the work and all of the effort that goes into building a business out of nothing is made even sweeter when that work can become the basis for your children’s financial stability for the foreseeable future.
However, selling a business to a family member isn’t as straightforward as it sounds. In an ideal world, making this transition would be as simple as a verbal agreement, shaking hands, and moving on once the business was in the hands of the new owner. But of course, in the real world, nothing is that simple.
Understanding the implications of transferring your business to a family member can be a big part of retirement planning for business owners. You want to make the transition as easy as possible while limiting the tax impact on all parties.
Here are some of the factors you need to keep in mind as you embark on this specialized component of small business financial planning.
When it comes to financial transactions among family members, there tends to be a high degree of flexibility. While this can ease these transactions in some ways, it can also cause headaches and stress. Just like many other aspects of smart small business owner financial planning, being as clear as possible will make your life significantly easier.
One of the first things to decide when you’re selling your business to a family member is what role you’ll play in the company’s future. Some family members welcome continued contributions, often in the form of an elder statesman who can serve as an ad hoc advisor of sorts. Other times, the buyer may feel that they need to stand on their own and would prefer to take over the business outright.
Thinking about your level of involvement in the future can help you to avoid any feelings of frustration or bitterness that might erupt based on potential misunderstandings. When you clarify these roles at the beginning and include them in the terms of the sale, everyone can leave the transaction feeling satisfied.
The familial relationship can have an impact on the selling price of your business, although that impact will be determined mostly by the seller’s situation. While the current owner can determine what they feel is a fair price for the business, it helps to have a third party come in and provide their own valuation.
When you’re selling a company, it helps to think of the price as a range of multiples based on the earnings. Unlike selling to an outside purchaser, when you’re selling to a family member, the price tends to be on the lower end of that multiple range. This avoids a burden of a high debt-to-income ratio for the family member and makes the business more attractive.
Of course, the amount you charge as the seller will also depend on your needs. Ensuring that they have enough money to live on is a key part of retirement planning for business owners. You need to make sure that you’ll be comfortable after the sale.
One of the most common mistakes in small business financial planning that involves family business decisions is to rely on verbal agreements. While you certainly want to trust your family, having an agreement set down in writing can be beneficial to everyone.
Getting everything in writing protects all parties involved, whether a dispute ever arises or not. The general theme throughout the process of selling a business to a family member is clarity, and that sometimes means setting aside the inherent trust that you would otherwise have with a family member. Buyers and sellers who forgo written contracts may regret it down the line; those with signed documents rarely do.
Price isn’t the only financial issue that’s affected when you’re selling to a family member. It’s not uncommon for payment terms to be slippery, with initial payments coming after long delays. Perhaps there will be a payment schedule with extremely generous terms. While this is fine, it’s important to be crystal clear about expectations for payment.
Let’s say that there’s a small business owner financial planning in New Jersey. He might decide to sell his business to his children, with payments being made over the course of five years and the money coming out of the cash flow for the business. Based on the applicable federal rate, he could loan his children the purchase money at an IRS applicable federal rate (AFR), which would be a very favorable rate.
However, in this case, he would also need to keep in mind retirement planning for business owners in South Jersey, which might also help to shape the payment schedule to ensure that he had the money on hand that he needed for his retirement.
For some small business owners, the idea of selling their company to a family member is repellent—they’d rather gift it. This is an option, of course—but it comes with some significant tax implications.
Although gift assets aren’t taxable until they exceed the gift tax limit, gifting rather than selling can still cause some small business financial planning headaches, mostly due to the cost base.
When a business is sold, that sales price becomes the cost base for the company. This number is the mark at which you start to owe taxes once you sell the business. When you gift a company, however, the tax base transfers, even if you’ve built the company significantly. This means that the new owners will owe far more in taxes if they decide to sell the business later on.
While selling a business to a family member might be more complicated than it originally appears, it’s still an excellent option for many families. You should be willing to engage the help of outside experts to facilitate the transitions. That way, you’ll avoid these pitfalls that could sour what should be a satisfying transition.