About 70% of Boomer-owned businesses are expected to change hands within the next 10 or so years, according to a 2006 article by Robert Avery of Cornell University.
Many of these owners have adult children or other relatives who work for them, and the owners may be thinking of ways to transition to retirement without a huge tax bill.
If you want your successors to own your business while you enjoy capital gains treatment for disposing of your ownership interest, follow tax rules scrupulously. Your successors can end up with 100% ownership of your corporation, you get the payout you want, and it won’t cost your successors a penny.
Here’s how the transaction should be set up:
- Assume you own 100% of your corporation (it doesn’t matter whether it’s a C or S corporation) and you have two adult children who work for you. You want them to own the business so you can retire to a nice community in a better climate and enjoy the fruits of your labor. You give some stock to each child; the amount is up to you. There’s no income tax when you give shares to your children. For federal gift tax purposes, you can give up to $13,000 worth of stock in 2012 with no tax (or $26,000 if you are married and your spouse consents to the gift).
- Now the corporation redeems all of your stock. If the corporation has sufficient cash, it can pay you the full redemption price. If not, the corporation can give you an installment note and pay you off over a fixed period (say five or 10 years).
Legal results: Following the redemption, your children own 100% of the corporation. You are no longer involved in the company (other than as a creditor if you are paid in installments).
Tax results: The redemption is treated as if you’d sold your stock to the corporation; this “sale” is taxed at the favorable capital gain rate (15% in 2012). If the corporation pays you out over time, then you report your gain over the period of the installments (unless your tax picture favors opting out of installment reporting so that you pick up all of the gain in the year of the redemption). Your children are not treated as having received a dividend from the corporation, even though they now own the entire business without any personal cash outlay.
Traps: This favorable redemption rule does not apply if you retain any interest in the business other than as a creditor (i.e., one who is owed money from the corporation). Caution is advised if you want to remain as a consultant or a board member; in some situations these positions can be considered a retained interest that prevents favorable redemption treatment. Doing the arrangement incorrectly can mean:
- You’re taxed on the proceeds as dividend income (which may not be taxed favorably after 2012 if you’re considered a high income taxpayer).
- Your children may be burdened with dividend income as well.
Because of the need to follow tax rules exactly, it is wise to work with a knowledgeable tax advisor who can help you structure the arrangement. You can also review this arrangement in a private letter ruling.