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In the last issue, we began the important discussion of determining how to choose the most appropriate exit path to successfully transfer your company to a business-active child. As is the case with any exit path scenario, the first step in choosing an appropriate exit technique is identifying your ownership transition objectives. After you have set your exit objectives (as we discussed in the previous Exit Planning Review™ issue), the next step is to align your objectives with the most advantageous exit path.

When choosing to transfer your ownership to a business-active child, there are a variety of options available to meet your unique business exit needs. Three of the most common business-active child transfer options include gifting ownership, selling ownership and transferring ownership via a stock bonus.

In the following article, we will compare the first two options – selling ownership and gifting ownership. We will base our discussion on the Ted Stevens case study we introduced in the last issue. In this case study, Ted Stevens wanted to transfer 20 percent of his $5 million S corporation to his business-active child, Sharon O’Meara, as soon as possible. As we discussed earlier, Ted also did not need any money from this initial transfer of ownership to meet his other exit objectives.

Scenario No. 1 – Sale of Stock

In most cases, a business-active child to whom a business owner would like to transfer ownership has little or no money to use to buy the business. In this situation, a purchase is usually financed with a promissory note. In Ted’s case, if Sharon purchases 20 percent of the business for $650,000, she will receive 20 percent of the S distributions generated by the free cash flow, or $200,000 per year, after the transaction. Sharon will owe about $80,000 per year in tax on company earnings since taxable profit is equal to free cash flow, leaving $120,000 per year for promissory note payments. Assuming a conservative interest rate on the promissory note (5 percent), the note will be paid in full in about 6 ½ years (76 months).

Ted will receive total principal payments of $650,000, which will result in $520,000 after a capital gains tax of $130,000 is paid. The total net taxes paid by all parties in this transaction, as compared to taxes that would have been paid by all if the transaction had not occurred, are essentially equal to the capital gains tax that Ted pays on receipt of stock sale payments, or approximately $130,000.

It is important to note in this scenario that Ted received payments of $650,000 – money that he really didn’t need and a portion of which may well be part to his estate for estate tax purposes and therefore taxed at his death.

Scenario No. 2 – Gift of Stock

If you are like the majority of business owners who are primarily interested in a transfer to a business-active child, then you may believe that you can “just gift” ownership to your child. However, this strategy may not be as simple as it sounds and it may have unintended tax consequences. You may try to use your annual gift exclusion to transfer business interests, but even in this situation, a married business owner can only transfer $24,000 worth of stock per year (based on 2007 allowable gifts). At this rate, it would take about 27 years for Ted to gift just a 20 percent ownership interest to Sharon—assuming no growth in value of the company.

If Ted chooses to transfer the 20 percent ownership interest to Sharon now, he can use part of his lifetime unified credit exclusion. The entire 20 percent ownership interest, with a value of $650,000, can be transferred at one time with no immediate income, capital gain or gift tax consequence. The tax consequences will occur later; however, when another asset in Ted’s estate, having a value of $650,000, is subject to estate taxes because that portion of the unified credit was used in gifting ownership to Sharon. This results in an eventual estate tax of approximately $292,500 at Ted’s death.

When you decide that the best exit route for you and your company is to transfer ownership to your business-active child, it is important to understand the tax and other implications associated with each transfer technique. Although selling ownership or gifting ownership to your business-active child may initially sound like the best options for this type of business transfer, each of these two options have potential tax disadvantages. In the next Exit Planning Review™ article, we will look at another planning concept used in transferring ownership to a business-active child – the stock bonus plan – which can be a more tax effective method in many cases, especially if you don’t need to receive money in exchange for the stock or the future cash flow attributable to the transferred ownership.

If you have any questions about transferring your company to a business-active child by selling ownership or gifting ownership, please contact us to discuss your particular situation.

Subsequent issues of The Exit Planning Review™ discuss all aspects of Exit Planning. The provider of this Newsletter (Paul Honeycutt) offers you unbiased information about what you may need to know — How To Run Your Business So You Can Leave It In Style™.