Business Succession: 3 Ways to Transfer Ownership

May 17, 2024 Austin Jarvis
For entrepreneurs, retirement planning should include decisions about their company's future. Here are strategies to consider for successfully transferring ownership of a business.

Every business starts out as somebody's passion project—which is why stepping away can be so difficult. But the only thing more daunting than coming up with a succession plan is doing so on short notice.

Having helped countless business owners, I've seen firsthand the high costs of deferred or inadequate succession planning. Some owners may assume an heir is interested in taking over the business, only to find out too late that they have no such desire. Others might believe their company is worth more than it actually is, which can make selling difficult, if not impossible.

In short, successfully transferring your business to a new owner takes a pragmatic and proactive approach. Although it's never too early to begin planning how to divest from your business, at least five years before a planned sale or transfer is best, allowing you time to consult with heirs and possibly restructure.

With that said, here's what to consider as you get started.

Valuing the business

Whether you're gifting or selling the business, you'll need to assess its value. Owners who are emotionally attached to their company may have a difficult time doing this objectively, so it's wise to work with a qualified business appraiser who can help determine not only an appropriate valuation but also the proper metric by which to measure it. The three most common methods of business valuation are:

  • Cost-based, which subtracts the fair-market value of a business's liabilities from its assets.
  • Income-based, which estimates a business's value according to its cash flow.
  • Market-based, which looks at comparable companies to determine value.

The American Society of Appraisers, a good accountant, or an attorney should be able to refer you to an appraiser specializing in your area of business. Industry associations can also help.

Once you have an appropriate valuation, consider which common strategy for transferring ownership of your business best fits your situation and goals.

1. Gift it to family

Many owners dream of their kids taking over the family business. While some heirs will jump at the opportunity, others may want to quickly sell their stakes. Even if your kids embrace taking over the family legacy, they could lack your business savvy and put the business at risk.

The most successful family successions tend to involve heirs that start at the bottom or work outside the firm to prove their mettle as potential entrepreneurs. Family members who work at the company for many years can gain a full understanding of its day-to-day operations, its long-term growth plan, and its finances and debt obligations. Plus, they may forge strong relationships with employees, vendors, and clients.

Still, the survival of a family business across multiple generations is notoriously difficult, so it's critical to start your succession planning with a frank assessment of who has both the desire and the aptitude to take the reins. You may ultimately decide to exclude one or more heirs from the company, in which case you might want to compensate them in some other way in your estate plan.

Finally, you'll want to consider the tax ramifications of gifting the business, which will depend on how you pass it on:

  • In its entirety, at once: You can give a lifetime maximum of $13.61 million for 2024 ($27.22 million for married couples) without triggering gift or estate tax. Should the combined value of your business and your estate surpass this amount, the taxes will be steep: up to 40% of the amount that exceeds the limit. That said, when the Tax Cuts and Jobs Act of 2017 sunsets on January 1, 2026, these lifetime limits may be roughly halved unless Congress intervenes.
  • In pieces, over time: If you want to continue drawing income while gradually stepping away from management responsibilities, you could portion out your business over several years. Doing so allows you to use the gift tax annual exclusion ($18,000 per individual, or $36,000 per married couple in 2024), which helps reduce the amount of lifetime estate/gift exemption needed to facilitate the transfer without incurring gift taxes.

If you don't have family or your children to continue in your footsteps, you could name a colleague or employee as your successor. However, the IRS generally will treat the gift as compensation, potentially leaving them with a heavy tax burden.

2. Sell to family or a colleague

If you can't afford to gift the business to your heirs, you could sell it to them instead. Selling to co-owners or key employees can also make for smooth handovers, especially if you've spent years laying the groundwork, slowly offloading duties to others so clients won't notice a transition. One common hurdle to selling, however, is whether the buyer has the capital to purchase the business outright.

In that case, you could sell the business for less than the appraised value—though the difference in price will count toward your lifetime gift and estate tax limit, which will necessitate filing a gift tax return, and if the buyer is a colleague, they could owe taxes on the reduction. Be sure to consult with a tax or estate planning attorney who can provide guidance on how selling at a discount could affect your estate plan.

To avoid tax implications, a seller-financed, long-term installment note might be a viable solution. Instead of paying you a lump sum, the buyer would send you fixed, regular payments over a set number of years. Future business revenue would support the debt obligation, and the company's stocks, assets, and buyer's personal guarantee would secure the note.

For example, if your business is valued at $4 million, you could establish an installment note in which the buyer agrees to pay you $200,000 plus interest annually for 20 years. The note's regular payments can make the purchase more manageable for the buyer and provide steady income for you. Plus, if you sell for a gain, receiving payments in increments can help spread your tax liability over several years.

Just make sure the buyer can keep the company going long enough to repay you. Because payments will generally rely on the success of the business, the inability of the buyer to pay the note in full or on time could extend the timeline of the agreement. However, you could stipulate that you have the option to regain operating control or to buy back the business if the buyer is unable to meet their debt obligation.

One downside of a long-term installment sale is you may receive little to no funds at the closing of the deal. If you would rather receive the full valuation of your business, traditional financing, such as a Small Business Administration (SBA) or other bank loan, might make more sense. Outside funding also allows the buyer to gain full or partial ownership rather than merely operational control.

3. Sell to a third party

This option is perhaps best suited to more turnkey operations, like a restaurant or retail shop, rather than a business that's reliant on the owner's unique brand or expertise. Often, a profitable, stable business that has followed professional management and accounting standards may be particularly attractive to a private equity firm. These entities often have a large amount of capital, so you can generally expect to receive full or partial payment for the value of your business at closing. And if your business has growth potential, the firm may also provide funds needed for expansion.

Be aware that selling to a private equity firm may require you to remain engaged in business operations after the sale for a specified time to help ensure a seamless transition to new ownership or management. The firm could also prevent you from withdrawing cash from the business prior to the sale.

Selling to an outsider can be complex—typically requiring lengthy negotiations and potentially triggering significant taxes—so many owners opt to work with a team of specialists, including a broker who can identify the strongest buyers and a tax attorney who can help plan for the tax consequences of a profitable sale.

What's next?

By constructing a succession plan alongside a retirement plan, you can not only help make sure your cash flow needs are met but also think about what will give your life meaning after you've handed over the reins. Will you keep a hand in the business or move on to the next stage in life? Planning well and early can help make it easier to find the option that's right for you.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness, or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

This information does not constitute and is not intended to be a substitute for specific individualized tax, legal, or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner, or investment manager.
The information and content provided herein is general in nature and is for informational purposes only. It is not intended, and should not be construed, as a specific recommendation, individualized tax, legal, or investment advice. Tax laws are subject to change, either prospectively or retroactively. Where specific advice is necessary or appropriate, individuals should contact their own professional tax and investment advisors or other professionals (CPA, Financial Planner, Investment Manager) to help answer questions about specific situations or needs prior to taking any action based upon this information.

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