Passing the Torch: Transitioning a Small Business

Some people are hard-wired to work until their last day, and good for them.  Most of us, however, look forward to a time when we can make our own schedule filled with activities we want (or our spouse wants) to do.  For small business owners that transition can be hard to figure out. Concerns range from making sure the owner gets to enjoy the value of the business he or she has built to taking care of the people who helped the business succeed in the first place.

The most obvious solution is to find someone who wants to buy the business and carry it on.  Depending on the industry that may be easier said than done.  Assuming the business has a market for buyers, the chief concern after maximizing the sale price is ensuring that the employees will be treated fairly and that the new owner will not tarnish the old owner’s good will.  Agreements can be drafted to ensure all that, but in the end, they can be very hard to enforce, and the old owner may have to turn to the courts to make the new owner follow the agreement or to take the business back.

Sometimes the better solution is to transition the business to someone who has been involved in it for a time; a loyal employee or a family member who has learned the trade and knows the culture the owner wants to maintain.  There, the option of a straight sale remains, but it may require some creative financing.  Most likely the owner will need to finance the purchase unless the business has enough value to collateralize a commercial loan.

If the owner must finance the purchase, there are several options to help minimize the tax impact.  The first is to sell the business in exchange for a promissory note that will be paid off over time.  The owner can then pay taxes on the sale as payments are received.

If the owner wants to minimize income taxes while freezing the value of the business for estate tax purposes, the sale can be to a special trust (called an intentionally defective grantor trust) that exists for estate tax purposes but not for income tax purposes.  The sale is recognized for estate tax purposes but not for income tax purposes, so the value of the business, as it grows, is not included in the owner’s estate but the sale price is, and no income tax is generated.

Alternatively, the owner may choose to make the transition a lifetime gift or at death.  However, when the business is given to some parts of the family and not others there can be resentment issues that lead to litigation.  While there are ways to minimize the risk of family squabbles, the ultimate goal is making sure everyone feels like they were treated fairly.

If you own a business and are ready to pass it on, please seek professional counsel to help you transition the business in the way you think best.