By Margaret Flowers, CPA, Harris CPAs
Your hard work over the years had paid off and now you have a Company that is strong, has valuable employees and at some point you will want to retire. Many business owners do not think about ownership succession until they are ready to retire. This is a mistake. Transferring ownership of the business takes time and planning.
So what are your options for transferring ownership to the next generation? In this article, we will review your options and the tax ramifications so you can make the best decision and start planning ahead.
Sell to a third party. In today’s market this is often a strategic buyer or venture capital firm. If you sell to a third party, you will pay capital gains on the sale and a new management will come into the Company. The buyer may ask you to stay on in an advisory role for a certain amount of time, but generally you will not be involved in management decisions. You will no longer have any control over corporate culture or vision. If you are considering selling to a third party, you should have an independent valuation done on your company and work with your CPA to make sure the Company retains the most value.
Sell to a key employee (or group of employees) or family member. By going this route, you will pay capital gains on the sale and will generally assist in the management transition. This will ease the transition and help you to maintain your corporate culture and company environment, creating a stable transition for your employees. This can present an issue if the employee(s) or family member does not have access to sufficient cash to buy your ownership from you.
Create an ESOP (Employee Stock Ownership Plan). Under an ESOP arrangement, there are different ways of structuring the deal in order to avoid capital gains or avoid income tax on the earnings of the business. The ESOP is a way to establish the next generation of management of the Company while providing a stake in the Company to all employees so they are engaged and motivated to improve Company performance.
So how does this work? An ESOP Trust is created and buys the Owners’ stock. This can be done in incremental purchases or all at once. The ESOP Trust is a qualified retirement vehicle for your employees. Each year contributions are made to the Trust and are allocated to each employee’s account based on the rules identified in the Trust. The employees will then be subject to a vesting schedule and will receive their vested funds upon termination, retirement, disability or death. The selling shareholder(s) will continue to run the Company while they actively train the next generation of leaders to take over when they are ready to retire. In order for a Company to be a good candidate for an ESOP, the Company should have the following attributes:
- Company should be later in its life-cycle and have strong financial statements, not overly leveraged
- Earnings should be relatively stable and growing at a modest rate
- Leadership and management should be strong with strong 2nd and 3rd tier leaders ready to take the reins
- Company should have strong cash flow to cover the stock purchase or debt coverage in a leveraged transaction.
Another issue to be aware of is the effect of creating an ESOP on your balance sheet. Your bank and bonding companies should be part of the conversation in the process as your financial ratios may be impacted by the transaction. If you have debt covenants in place, you will need to discuss this with your bank to ensure that you don’t fall out of compliance.
If you are ready to start planning your Company’s future, please contact our office and we would be happy sit down and discuss the options with you and what steps need to be taken to ensure that you have the most value in your Company. Remember all of these options take time to implement so it is best to have your plan in place well before it is time to act on whichever method you have chosen.
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