Family ownership succession can happen between a number of different people or groups. Parents may transfer ownership to one or more of their children. Siblings may transfer ownership to each other or the next generation (i.e. nieces and nephews). Grandparents may even skip a generation and transfer ownership to a grandchild if their children aren’t interested or capable of taking over the business.
With each of these transitions, the existing owners are selling or transferring stock in a corporation or interest in an LLC. There are three common structures for the sale of family ownership:
- Cross Purchase. A cross purchase involves one family member selling the ownership to another. In other words, the ownership is directly transferred from one family member to the other. From a tax standpoint, this transaction is almost always characterized as a capital gain which is favorable to the selling family member. The buying family member will likewise benefit from a tax standpoint. As the buyer takes distributions from the company, they’re offset by basis and are tax free. However, if the business is taxed as a C corporation and the seller has financed the purchase, the company will need to declare a dividend so the buyer is able to make payments on the promissory note. The dividends will generate income tax to the buyer and increase the tax cost of the succession planning.
- Redemption. A redemption is when the company buys the ownership of the family member. This has the legal effect of the ownership essentially going away. In other words, the departing owner’s percentage gets redistributed amongst the existing owners. This is a planning option when the existing owners will take over from the departing owner. From an income tax standpoint, this structure is generally favorable to the seller. It creates a capital gain to the seller which is generally at favorable rates. However, if the selling owner is not being completely bought, the tax consequences can be complicated if the transition involves a C corporation or in some cases an S-corporation. Finally, a redemption benefits the owners who are continuing the company if there’s seller financing because the company can make payments to the departing owner without having to distribute funds to the buyer.
- Deferred Compensation. This planning option doesn’t entail a transfer of ownership, but it’s a structure that can be used to pay the retiring owner and done alongside the ownership transfer. It’s comparable to the selling or departing owner receiving a salary over a period of time. For the seller, it’s generally not advantageous from a tax standpoint because the payments are treated as ordinary income which is taxed at a higher rate than capital gains. However, the selling owner’s income is oftentimes much lower after the sale so the income tax on the payments may not be as significant. Finally, this planning is beneficial to the buyer because the company is able to deduct the payments and reduce its taxable income.
If you have any questions about family ownership succession and these planning options, feel free to contact me at phmulder@cunninghamdalman.com.
