By: Ethan Lee, CPA, ABV, CFF
Amid the storm clouds of the COVID-19 pandemic there is a silver lining for business owners considering a transfer of ownership to key employees and/or family members. These so-called “internal transfers” are a preferred transition strategy for owners who are looking to ensure the future of their businesses while making ownership more attainable for the next generation of owners. This short article will focus on two internal transfer options that can be a win-win for both parties, particularly in the current business and economic environment.
Transferring Minority Interests at Discounted Value
By way of foundation, both options involve transferring minority (less than 50%) ownership interests at discounted values. Minority ownership interests typically do not possess rights to have the final say in business decisions; they are also more difficult to sell than an entire business. Accordingly, a minority interest is worth less than its pro rata value in a business. For example, if a business is worth $1,000,000, it may seem logical that a 25% interest in that business should be worth $250,000. However, for tax purposes that same 25% interest may only be valued at $150,000 because of discounts for lack of control and lack of marketability that are applicable. This discounted value is an important planning consideration for both internal transfer options discussed below.
Internal Transfer Option 1 – Selling Minority Interests to Key Employees
The first option is selling a minority ownership interest to a key employee. This is a “golden handcuff” strategy utilized by business owners who are searching for ways to secure talented employees who can take over ownership. As one might imagine, this strategy is especially popular in businesses that are highly dependent upon existing owner(s) for ongoing operations, such as professional practices. To illustrate this option, suppose a CPA is approaching retirement age and has a talented employee who is interested in taking over the practice within the next few years. The CPA agrees to sell 25% of the business to the employee in each of the next 4 years. The employee is able to purchase the business in increments at a discounted value and begin to experience the benefits of ownership. The CPA is able to ensure the continuity of the practice and reap other benefits during the transition that could offset the discounted value of the transferred interests. This is a win-win scenario.
Internal Transfer Option 2 – Gifting Minority Interests to Family Members
The second option entails gifting a minority ownership interest to a family member. In this scenario, the priority of the owner(s) is typically to keep the business in the family and not to realize optimal value for their ownership. This is a common strategy employed for estate planning purposes especially by those who might be interested in taking advantage of the annual exclusion (currently $15,000 per gift per donor). For example, mom and dad own the family business and want to transfer the business out of their estate to each of their four children. They decide on a plan to gift 5% of the business to each child each year (20% total) for the next 5 years. This means that mom and dad can each gift 2.5% to each child each year. Let’s assume that each 2.5% minority interest is valued at $15,000 on a discounted basis. Because mom and dad can individually gift $15,000 to each child each year, they will be able to successfully transfer the business to their kids without using any of their lifetime exclusion for estate tax purposes. The children get ownership of the business without having to use up precious cash. Another win-win scenario.
Opportunity Created by COVID-19 Pandemic
If either of the options discussed above resonate with you, the saying “there’s no time like the present” could certainly apply. The COVID-19 pandemic has already negatively impacted businesses and created significant economic uncertainty. These risk factors decrease business values and can create an ideal planning opportunity for internal transfers where the goal is to transition ownership at a discounted value.
From a business valuation perspective, a valuator must consider what was known or knowable as of the effective date of the valuation. Accordingly, there may be a short window of opportunity to transfer ownership at a [more] discounted value. It will depend on how things play out with the COVID-19 pandemic and its impact on specific businesses. Please contact us if you would like to discuss either of these internal transfer options, or if there is another business transition plan you would like to explore. Cooper Norman is here to help.