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One way to realize the American dream is to start a business, become wealthy and eventually sell the business for a nice profit. The sale is just one example of a transfer of business ownership. Other examples include selling a portion of the business, selling business assets, reapportioning ownership interests among multiple owners, partner retirement and bringing on a new partner. In most cases, ownership transfers have legal and financial dimensions that vary by the type of transaction and the type of business structure. In general, owners work with lawyers and accountants to ensure that all steps are correctly executed.
Ways to Transfer Ownership of Your Business
Ownership can transfer in several ways, depending on whether the whole business is being sold, a partner/owner/major shareholder leaves, or a new one joins the business.
Adding a Partner
The operating agreement describes how new partners can be taken on and how much the new partners will have to pay for their ownership interests. The transaction is usually executed with cash, although other arrangements are possible.
Sale of Business
There are two major methods to sell a private business:
- Cash or financing: The buyer pays cash for the company, either from personal resources or via a loan. The residual method is used to determine the distribution of money for each asset and whether gains are ordinary income or capital gains.
- Owner-financing sale: This is in effect an installment sale. The buyer pays for the business over time on terms set by the seller. The seller might offer to mentor the buyer during the financing period, that is, until the full purchase price is paid. The seller undertakes the risk that the buyer will default and forfeit the business back to the seller. If a bank had instead been used to finance the sale, the owner would receive the money upfront and the bank would carry the default risk.
In a lease-purchase, the lessee runs the business for the lease period. This is a good deal for an erstwhile buyer afraid of making a bad purchase. At lease end, the lessee can buy the business for a set price, set up an owner financing deal, take on another lease, or simply walk away, giving control back to the owner.
Family Member Transfer
If you want to slowly give your business to a family member, you can avoid gift taxes by doing so in $15,000 annual segments. If your family member is your beneficiary, you can avoid estate taxes on your business at your death as long as it is valued below $5.6 million, assuming you haven't already tapped into the lifetime gift tax exemption.
How Your Business's Structure Affects Transfers of Ownership
As a general proposition, money flows, papers are signed and taxes are paid when a business is transferred. The type of business structure impacts all of these activities.
By definition, a sole proprietorship has only one owner. You therefore can't "sell" the business, only its assets (and perhaps its liabilities). The sole proprietorship dissolves as a result, and the buyer can use the assets in any new type of business structure. Assets are sold using the residual method to determine how the consideration is paid by the buyer. In this method, each asset is evaluated separately, based on its book value and any attached intangible assets such as a portion of the selling company's goodwill, patents and so forth. A sales contract should be created, showing the amounts paid for each asset. Normally, no state filings are involved in this type of transaction. A single-member limited liability company is treated the same as a sole proprietorship.
As an example, Joe runs a successful woodworking shop as a sole proprietorship. He wants to retire and finds someone willing to buy his equipment, his company name and his customer list. The book value of the assets is $45,000, and the buyer is willing to spend $60,000 for the purchase. The residual method is used to assign a profit to each asset, which is the basis for the taxes Joe will incur on the sale. Joe and the buyer execute a sales contract to memorialize the sale.
In a partnership, two or more partners have specified interests in the company, that is, a percentage of ownership that is outlined in an operating agreement. To make way for a new partner, the current partners must give up some of their interests. On the other hand, a current partner might retire and distribute their interests to other partners. In any case, the operating agreement will have to be modified. A buy-sell agreement might also be in effect that governs the change of ownership. Year-to-date income and loss is allocated on the day of ownership transfer, using established methods such as interim closing method or proration method. State regulations on partnership registration vary, so the partnership might have to file forms with the state government declaring the ownership change.
Let's assume that Joe, Bob and Jill are equal partners in their woodworking business. Joe is retiring and will distribute his 33.3% stake in the company's $60,000 of capital equally to Bob and Jill, as per the operating agreement. The company has earned $90,000 for the year as of the date of ownership transfer. Joe receives $30,000 in income and another $20,000 for his share in the business's capital. The operating agreement is updated to show a 50–50 ownership by Bob and Jill, and a new filing is made with the state. The annual Schedule K-1 tax forms will reflect the distributions resulting from the ownership transfer.
Limited Liability Company (LLC)
Each owner of an LLC is called a member, and each member owns a percentage membership interest of the company. The LLC's operating agreement specifies any buy-sell provision that governs ownership transfers. It also might specify how member buyouts work, who can become a member and how an ownership transfer must be approved.
If the woodworking company owned by Joe, Bob and Jill had been set up as an LLC, the procedures followed at Joe's retirement would be roughly the same. However, ownership would be transferred by Joe selling his shares to Bob and Jill. The LLC draws up a new operating agreement and files a Certificate of Amendment with the state to update the names of the members. New share certificates are issued to the remaining members.
Ownership percentages are based on the number of shares owned. In a public corporation, these percentages are constantly changing due to stock trading and are tracked by a transfer agent. In a private corporation, shares transfer less frequently, and the shares may have to be held for a year before they can be publicly resold. Because the business is private, its current value will need to be established so that the stock can be priced. There is no limitation on the number of shareholders in a C corporation.
For example, Three Woodworkers Inc. has 900 private shares split equally between Joe, Bob and Jill. Bob and Jill agree to buy Bob's 300 shares (150 each) for $200 per share, and the transfer is recorded in the corporation's books and records. Bob records a long-term capital gain of $50 a share on the shares he sells, and he pays the 15% capital gains tax on those shares.
An S corporation is similar to a regular C corporation except that income and expenses are passed through to owners without being taxed at the corporation level. Another difference is that an S corporation cannot have more than 100 owners or else it will lose its S-corp status and become a C corporation. S corporations often have bylaws restricting who can receive shares, such as another corporation that might cause the number of owners to exceed 100. The corporation must value its shares, draw up and execute a sales agreement that calls for the distribution of money and shares, and file Schedule K-1 forms reflecting each member's share of profits and losses for the portion of the year up to the ownership transfer date.
The C corporation example for Joe, Bob and Jill also suffices as an example for an S corporation.