Posts

Succession Planning and Taxes: What You Need to Know

/0 Comments/in /by

If you own a business, planning for future transitions and taxation should start now.

Key takeaways

  • Business structure matters for taxes, whether it’s a pass-through entity, S or C corporation, or another entity
  • The Tax Cuts and Jobs Act lowered the corporate tax rate, and it also created the qualified business income deduction for pass-through entities
  • The gift tax exemption was increased by the TCJA, but the increase sunsets in 2025

By now, you may have secured your estate plan and tax planning responsibilities. But what about your succession plan?

If you own a business and don’t put the right plan in place, you can leave it vulnerable to unnecessary taxes and possible conflict about who owns what. The brand, company reputation, and wealth you’ve built could be put in the balance long term. You’ve worked hard to create a successful business. So, why not ensure the company is valued and passed on properly once you’re out of the picture? 

Taxes are one of the most important factors that play a role in succession planning. Keep these considerations in mind when you’re working through your plan.

Business structure and taxation

The type of business structure you operate as matters a great deal for taxes. You want to ensure that your entity will set up your business for many years of success into the future. 

Of course, succession planning shouldn’t be the only thing to consider when deciding on the right structure, but it’s still an essential piece to the puzzle. The structure is a major factor that significantly impacts personal and business taxation when business ownership is being transferred.

Closely held businesses can be sole proprietorships, partnerships, LLCs, S corporations, and C corporations. Let’s walk through some considerations for each entity type.

Sole proprietorships (and default LLCs)

The sole proprietorship is for single business owners, and there is no separation of personal and business assets and liabilities. An LLC offers liability protection, but it is still taxed like a partnership unless the owner(s) elects to become a corporation. Sole proprietorships and some LLCs dissolve if the owner dies, but a succession plan can ensure that business assets pass to an intended inheritor.

Partnership

Partners within a general partnership have unlimited personal liability that can negatively impact personal assets. Those in a limited partnership have liability only as much as their investment. Sometimes, these reasons are enough to avoid the general partnership setup. 

However, the owner of a family limited partnership can help lower the tax burden when wealth is transferred to the next generation. Family limited partnerships help you reduce your tax burden because they minimize your taxable estate when you transfer some business value to your heirs. When you pass on limited partnership interests, they are eligible for the annual gift tax exclusion, so shares can legally be reduced when transferred. 

C corporation

Many businesses are C corporations, with an essential characteristic being that the business is a very distinct entity from the business owners. This means the liability is not on the owners, both financially and legally, so it’s a form of protection that sole proprietorships and partnerships don’t offer. For succession considerations, it can be more tax-efficient to have personal affairs completely separate from the business’s affairs.

S corporation

S corporations also offer that separate-entity protection like a C corporation. But they are taxed as a pass-through entity, meaning that the business doesn’t pay corporate taxes, and any income or losses are reported on the individual income returns of shareholders. Companies must not have more than 100 shareholders to convert to an S corporation. 

As a pass-through entity, there are several tax advantages when succession planning and transferring ownership. It’s easier to move funds from the business entity to a shareholder, and ownership transfer is easier with fewer tax and regulatory requirements. 

However, keep in mind that if an initial public offering (IPO) could be in a business’s future, the benefits of instead choosing a C corporation may outweigh these other succession considerations. 

Impacts of the Tax Cuts and Jobs Act

The Tax Cuts and Jobs Act (TCJA) of 2017 implemented a few changes that may affect a succession plan. The C corporation federal income tax rates were lowered from 35% to 21%, and the individual tax brackets were also reduced from between 10% to 39.6% to between 10% to 37%. You can use these new numbers and estimate personal income, business income, and dividends to see which structure would benefit you the most.

The TCJA also created a qualified business income (QBI) deduction, which allows qualifying pass-through entities to deduct 20% of qualified business income, but it includes phase-out limits. There are a few ways to lower income to stay below the phase-out limit, including retirement plan deductions. 

For example, you could set up a retirement plan like a SEP or 401(k) and contribute up to the plan’s limit, lowering income to qualify for the deduction. A defined benefit plan will allow you to make the biggest contributions while taking advantage of tax deferment and additional asset protection from creditors.

Gift and estate taxes

Creating a succession plan now keeps you ahead of the game for substantial taxes associated with the business, including estate and gift taxes. The right strategy for a transfer of ownership can help you reduce or even eliminate some of them.

If you decide to sell your business before you die, you may have to pay capital gains tax. However, no matter when you sell, proceeds could help cover your current lifestyle or future estate taxes. The gift tax won’t apply to the sale as long as the price is at least equal to the full fair market value.

There is currently an increased estate and gift tax exemption from the TCJA, now at $11.7 million per person or $23.4 million per couple for 2021. Transfers of interests made within a limited partnership are eligible for the gift tax exclusion, and the value of shares can be lowered when they’re transferred. This means your heirs will be able to reduce the taxes they have to pay. However, keep in mind that the increase is currently set to sunset on January 31, 2025.

Another option of note is the grantor retained annuity trust (GRAT), which may allow you to transfer business assets to your children. They will still be able to earn income, and a GRAT may also make sure that your business isn’t subject to high taxes as its value appreciates. Just keep in mind that a GRAT must be held for a certain number of years, and you must outlive that term to receive all the estate tax benefits.

Working with a tax professional

All of these moving parts will impact how you approach succession planning. There is no one right strategy, and choosing one requires weighing multiple factors about your business structure, future plans, and family goals. 

Work with a tax professional who can help you customize a succession plan that will lower your tax burden and set up your company’s new stewards for success. You’ve worked long and hard to create your business—make sure things go smoothly when it’s time for you to step aside.

Contact Provident CPA and Business Advisors to talk with our team about succession planning and taxes. 

Should You Sell Your Business to Employees?

/0 Comments/in /by

Perhaps your employees would make the best next owners of the business. How do make that happen?

“I just work here.” This can sum up the perspective of an average employee who does not own stock or have any real ownership in an organization. There’s no tangible investment. Many individuals go to work to earn a paycheck, and a lack of engagement is reflected in attitude, morale, and productivity.

As a business owner, you may be looking for ways to change this value proposition for your top employees. Or you may want to earmark a specific internal successor or successors to sell the company to—and provide the means to do it—giving you options when it comes time to cash out.

Doing all of this has reciprocal benefits because it can also increase the value of the business. And sometimes, the best buyer for your company is your own employees.

Succession planning

Do you have an exit plan? It’s a question we ask all of our clients. Succession planning can be a complex process, something you shouldn’t only attempt to put in place when you are ready to step away from your business.

Business succession planning is a process of financial and logistical decisions about who will take over the organization. One of the biggest decisions is whether you will sell the business to an outside individual or organization, or to turn management and ownership over to members within your company, and potentially sell to them directly.

When to sell to an employee—and the advantages of doing so

The asking price of your business could likely exceed the capability of any employee to afford its purchase. You also may conclude that you have no employees capable or willing to succeed you as the business owner. These are signs that it might be wise to explore selling to an outside third party, or to start setting up mechanisms for them to afford the purchase (these will soon be explained under “Sticker shock”).

With planning and a commitment to building the value that your employees contribute to the company, a succession plan that sells the company internally can be your best choice—especially because of the lucrative tax benefits it offers.

Selling to your employees also provides peace of mind by providing business continuity. If you built an organization, you’ll probably care about what happens to it even after you no longer own it. Turning ownership over to workers who understand and contribute to the company culture provides assurance that it will continue to operate as intended.

There’s also the advantage of familiarity. Employees already know the details and value propositions of what they’re buying. It doesn’t obviate proper due diligence on anyone’s part. But as an owner, you will spend far less time identifying and attempting to sell your company internally than you would to prospects.

Sticker shock

Selling your business to employees may not be possible, though, as they often don’t have the means to purchase the company. You might opt to lower the price or otherwise offer concessions that make it affordable for them—but is this in your best interest?

A better choice is to help fund the sale of your business to your team through an Employee Stock Ownership Plan (ESOP). An ESOP paves the way to company ownership by allowing employees to own stock in your company without having to purchase shares.

After an ESOP is implemented, employees receive an ownership stake in the business as a part of their compensation. These shares are held in trust. They cannot be used while employed but must be liquidated if an employee leaves the company.

As a business owner, you have the option to use an ESOP as a way to fund the sale of your company to employees. The employees can use its value to buy your shares. This can happen as an immediate purchase if the ESOP has been in place for an extended period of time. Or, the ESOP can be funded through commercial loan financing.

In many cases, the sale of a company using an ESOP is not immediate. As the company owner, you finance the sale. The ESOP purchases your ownership and offers you a note that yields an attractive interest rate. Your employees now own the company, and you receive the sale price plus interest over time.

Some owners also opt for setting up and funding a dedicated ownership fund that—and this is also applicable to shares in an ESOP—an employee can use as collateral for an outside loan from the bank.

More options

Depending on the transaction’s structure, it can also offer tax advantages such as capital gains deferral. Selling your company to employees with an ESOP is just one of the ways you can plan a successful exit and maintain business continuity.

In many cases, you end up being the “bank” that finances the transaction. Do you have employees with access to capital but not enough for an outright purchase? You can assist them with the outright purchase by cosigning a loan. You can also structure a staged buyout that allows your employees to purchase the business and still benefit from your presence.

We can help you with expert advice on succession planning and exit strategies.