When we accept an assignment to assist a company in assessing its options to transfer ownership to the next generation, we have two primary goals in mind. First, we get a very clear idea of the goals and objectives for the existing owners, the new owners, and the company in affecting the transfer. Second, we want to achieve those goals and objectives as tax-efficiently as possible.
Business owners are often advised to redeem their stock in the company when transferring ownership. Redemptions are used for many reasons and are in many cases the necessary form to affect a transfer of shares. There are situations, however, when pursuing other options can save substantial amounts of income taxes by doing some thoughtful planning.
The hidden cost in redemptions is income taxes. The seller of the shares enjoys a relatively low tax rate based on capital gains. However, from the company’s perspective, a transaction to redeem shares is a capital transaction and the payments made for the shares are not tax deductible. That means the company has to pay for the cost of the redemption in after-tax dollars.
For example, if a company has to redeem stock for $1 million, it would have to earn approximately $1.75 million in order to have enough money to fund the $1 million redemption. That is a tax cost at the company level of $750,000! The key to managing this scenario is to establish ways to restructure the transfer and re-characterize the income. This is done via a combination of thoughtful transfer and estate planning.
Redemptions will continue to be used in many transfers; however, before deciding on that structure, consider the potentially immense tax costs before ruling out other strategies that are more tax efficient and can save substantial amounts of money.
If you would like to discuss these transfer options beyond redemptions, send me an email at Email.
What has been your company's experience with transfer options? Share in the comments.