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Alignment is important.
When it comes to the continuity of your business and preserving the wealth you’ve built with it, you need to properly align your corporate structure with long-term objectives, including how you intend to exit the business.
Many entrepreneurs have a general idea of what they intend to do with their company when they retire – sell it to employees or an outside purchaser or transfer it to children. But unless you also align corporate structure with a succession strategy – ideally at least five years prior to exiting the business – you could end up receiving significantly less than for it than you hoped.
How owner-managed and family-owned businesses are structured plays a key role in transitioning to another generation of ownership because this impacts both business and personal taxation and the ability of a company to transfer wealth.
Carefully aligning corporate structure with an owner’s exit strategy can open future options. Meanwhile, the right alignment can also propel growth, strengthen performance, build value, reduce taxes and develop a solid foundation for retirement.
Preparing a business for transition does not mean you’re obliged to move forward with a transaction. But should an opportunity arise, you’ll be ready to act on it.
Following are some common ways entrepreneurs exit their businesses and the corporate structure issues that can be addressed to optimize outcomes for each.
When entrepreneurs decide to sell their businesses, many make a common mistake: they start the process too late to maximize its value. Too often the proceeds end up being disappointingly less than hoped for.
When the shares of a business are sold, shareholders may be eligible to claim the $866,912 lifetime capital gains exemption (for 2019). However, if the company holds passive assets it could prohibit claiming the exemption.
Sometimes it’s possible to put into place a structure that facilitates multiplying the number of capital gains exemptions available. But structuring a company to remove passive assets and multiply the capital gains exemption cannot take place at the time of the sale; it must be done several years before a transaction takes place, otherwise there will be unintended tax consequences.
Transferring a business to the next generation can also trigger income tax issues. There are ways to mitigate the tax consequences of a transfer, but these strategies must also be arranged in advance of the transaction.
Non-arm’s length transactions have different tax consequences than do arm’s-length sales. For example, if an owner utilizes the capital gains exemption, this results in tax consequences to the children. At the same time, if an owner does not utilize the capital gains exemption, you end up paying more tax than necessary.
So, some planning is required. For example, it may be possible to set up an estate freeze, which caps the value of the business in the hands of the owner while future growth flows to the next generation. The owner can retain control of the business and family members don’t incur income taxes.
For this strategy, the owner exchanges common shares in the company for fixed-value preferred shares, and then issues common shares to the children. Any future growth in the company’s value is attributed to the common shares. These are not taxed until the children sell or gift their shares. This strategy also enables the children to gradually take on more responsibilities and participate in the growth of the business.
In some cases, employees may wish to take over the company but don’t have the capital necessary to purchase the business. One common solution is owner financing.
For this exit strategy it is important to have a corporate structure that allows the owner to retain control of the corporation or at least have a say in operations, given that you’ll bear most of the consequences should the business fail before employees are paid out. Unanimous shareholder agreements can also minimize risk.
Aligning your corporate structure with an exit strategy long before a sales transaction takes place enables you to control how and when you transition out of your business. It’s also an efficient way to reduce the risks and magnify the returns when you do so.
Really, it’s just smart business.
To learn more, contact Shane King, CPA, CA, MNP’s National Leader, Succession Services, at
Client Groups:Private Enterprise
Related Topics:Valuations; ExitSMART™; Small Business; Entrepreneurs; Selling a Business; Retirement
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