When you go into business with others, things don’t always work out as anticipated. Co-owners can disagree about the direction of the business and, as a result, one may want to leave the company. One owner may have a change in family situation or a desire to do something else. An owner may have health issues, become incapacitated, or simply want to retire. Or, as the pandemic has demonstrated, an owner may suddenly die (they don’t want out; they’re just out!). When an owner leaves the business, the departure triggers financial, legal, personal, and practical issues that need to be addressed. In 1960, Neil Sedeka’s song said “Breaking Up Is Hard to Do.” It doesn’t have to be. With the right attention and attitude, the parting can be amicable, and beneficial to all involved.
Financial and tax issues
The key decision is who leaves: you or the other owner? In simple terms, you can buy out the interest of the other party, or he/she/they can buy you out. In some cases, where there is an impasse on this question, the answer may be to simply dissolve the business and owners go their separate ways. If you have an operating agreement for a limited liability company, a partnership agreement for a partnership, or a shareholders’ agreement for a corporation, there should be instructions on how to proceed.
Obviously, the decision on what to do when one owner wants out turns on the reasons for the departure. For example, if your co-owner wants to move on to other things, you likely will continue the business on your own, or with other remaining co-owners.
Another financial issue is determining what the interest of the departing owner is worth. A valuation by a professional usually is necessary unless the legal documents for the owners and entity, such as a shareholder agreement, have a pre-set formula for fixing the price of the interest. Appraisals aren’t cheap, and it can be contentious when it comes to who gets the appraisal or appraisals and who pays for the bill. Should there be one appraisal? What happens with dueling appraisals by the seller and buyer? A satisfactory resolution will save money for all concerned.
Coming up with the funds to effectuate a buyout is often problematic. The owner(s) may lack the cash to do an immediate buyout. The buyout can be structured as an installment sale, which can be beneficial for the buyer and seller. For instance, any buyout may be delayed for a set period (e.g., one or two years) or until a business is profitable.
In the case of a corporation, the buyout can be arranged in two basic ways (there are hybrid options):
- The owner(s) can buy out the departing shareholder. The seller can obtain capital gain treatment for the sale; the buyer (the other owner(s)) gets a cost basis to their additional shares. There is no impact on the corporation for this arrangement.
- The corporation can do the buyout by redeeming the shares of the departing owner, assuming the corporation can afford this option. The impact on the seller depends on whether the corporation is a C or S, whether the interest is completely redeemed, and whether the departing owner has family members who continue to be shareholders. In other words, the departing owner may have capital gain or dividend treatment, depending on the situation. The remaining owners effectively increase their interests in the corporation because the ownership pie is divided in larger slices.
For a partnership or LLC, there are also ways to structure the buyout arrangement for the best financial and tax results for all parties.
When a two-owner partnership or LLC experiences an owner’s departure, the entity becomes a sole proprietorship (from a partnership) or a disregarded entity (from an LL). In both cases, check with the IRS to see whether a new Employer Identification Number (EIN) is needed. Also, depending on when the breakup occurs, the LLC may need to file a final partnership return for a short tax year.
Often the legal documents of the entity dictate the terms of an owner’s departure. Check the shareholder agreement, partnership agreement, or operating agreement for applicable terms. The terms impact legal obligations as well as tax results.
For example, shareholders may be contractually obligated to buy the shares of a departing owner. If, instead, the corporation redeems the shares, the remaining shareholders may realize a constructive dividend; the corporation is satisfying their obligation.
For partnerships, there is a special concern for liability that may arise after a partner leaves, which stems from actions that occurred while he or she was still a partner. Because partners are jointly and severally liable for partnership debts, this concern must be addressed in the buyout. An outgoing partner will remain liable to third parties if there are lawsuits for actions that arose while still a partner, unless the outgoing partner obtains an indemnification agreement from the remaining partners for this situation.
When it comes to financing arrangements that were made with third parties, be sure to address personal guarantees that had been made by departing owners. These are not automatically extinguished by a departure and cannot be addressed merely by sending a letter to the lender.
The departure of an owner may require notification to your state about a change in entity. For example, file a dissolution of partnership if you’re the remaining owner (now a sole proprietor). Check with your secretary of state to determine what you need to do for your situation.
Personal and practical issues
As in the case of a marital dissolution, some business breakups are amicable while others are downright hostile. Often, the tone of the breakup can be influenced by conciliatory actions on both sides where there is an understanding that the end result of having an owner depart on mutually agreeable terms is the best for all concerned.
From a practical perspective, be sure to decouple the departing owner from such items as:
- Company bank accounts
- Company business credit cards
- Computer access for the company’s website, cloud apps (e.g., QuickBooks), etc. (change passwords)
- Contact information for customers and vendors
- Social media accounts
Breaking up isn’t hard to do if you understand the ramifications to a change in company ownership and you get the parties to work together to achieve a swift and satisfactory result. Be sure to consult with a knowledgeable business attorney who can address all of the issues for the breakup.