Tax Implications of Business Succession
Posted by Cheryl A. Jankowski on March 17, 2025
When it's time to consider your business's future, succession planning can protect your legacy and set up the next generation of leaders or owners for success. Whether you're ready to retire, want to reduce your involvement, or need a solid contingency plan in case you're unexpectedly unable to run the business, exploring different succession strategies is key. Here are five options to consider, along with some of the tax implications.
Transfer Directly to Family with a Sale or Gifts
One common approach to succession is transferring ownership to a family member (or members). This can be done by gifting interests, selling interests, or a combination of both. Parents often pass the business to their children, but family succession plans can also involve siblings or other relatives.
Tax Implications:
- Gift Tax Considerations: You may trigger the federal gift tax if you gift the business (or part of it) to a family member or sell it to them for less than its fair market value. The annual gift tax exclusion (currently $19,000 per recipient) can help mitigate or avoid immediate gift tax in small, incremental transfers. Plus, every individual has a lifetime gift tax exemption. Depending on the value of the business and your use of the exemption, you might not owe gift taxes on the transfer. Keep in mind that when gifting partial interests in a closely held business, discounts for lack of marketability or control may be appropriate and help reduce gift taxes.
- Estate Planning: If the owner dies before transferring the business, there may be estate tax implications. Proper planning can help minimize estate tax liabilities through trusts or other estate planning tools.
- Capital Gains Tax: If you sell the business to family members, you could owe capital gains tax.
Transfer Ownership Through a Trust
If you want to keep long-term control of the business within your family, you might place ownership interests in a trust (such as a grantor-retained annuity trust or another specialized vehicle).
Tax Implications:
- Estate and Gift Tax Mitigation: Properly structured trusts can help transfer assets to the next generation with minimized gift and estate tax exposure. Trust-based strategies can be particularly effective for business owners with significant assets.
- Complex Legal Framework: Because trusts involve legal documents and strict rules, working with an attorney is crucial to ensure compliance and optimize tax benefits.
Engage in an Employee or Management Buyout
Another option is to sell to a group of key employees or current managers. This path often ensures business continuity because the new owners already understand the business and its culture.
Tax Implications:
- Financing Arrangements: In many cases, employees or managers may not have the funds to buy the business outright. Often, the seller finances part of the transaction. While this can provide ongoing income for the departing owner, interest on installment payments has tax consequences for both parties.
- Deferred Payments: Spreading payments over time can soften your overall tax burden by distributing capital gains across multiple years, which might help you avoid being subject to top tax rates or the net investment income tax. But each payment received is still taxed.
Establish an Employee Stock Ownership Plan (ESOP)
An ESOP is a qualified retirement plan created primarily to own your company’s stock, allowing employees to own shares in the business. It may be an appealing choice for owners interested in rewarding and retaining staff. However, administering an ESOP involves complex rules.
Tax Implications:
- Owner Benefits: Selling to an ESOP can offer potential tax deferrals, especially if the company is structured as a C corporation and the transaction meets specific requirements.
- Corporate Deductions: Contributions to an ESOP are usually tax-deductible, which can reduce the company’s taxable income.
Sell to an Outside Buyer
Sometimes, the best fit is outside the family or current employees or management team. You might decide to sell to an external buyer — for example, a competitor or private equity group. If you can find the right buyer, you may even be able to sell the business at a premium.
If your business is structured as a corporation, you may sell the business’s assets or the stock. Sellers generally prefer stock (or ownership interest) sales because they minimize the tax bill from a sale.
Tax Implications:
- Capital Gains Tax: Business owners typically pay capital gains tax on the difference between their original investment in the business (their “basis”) and the sale price. The capital gains rate depends in part on how long you’ve held the business. Usually, if you’ve owned it for more than one year, you’re taxed at the applicable long-term capital gains rate.
- Allocation of Purchase Price: If you sell the assets, you and the buyer must decide how to allocate the purchase price among assets (including equipment and intellectual property). This allocation affects tax liabilities for both parties.
Focus on Your Unique Situation
Succession planning is not a one-size-fits-all process. Each option presents distinct advantages and disadvantages, particularly in terms of taxation. The most appropriate approach for your situation depends on various factors, including your retirement timeline, personal financial objectives, and the extent of family or employee involvement. It is advisable to consult with our firm to ensure that you select a strategy that preserves your financial well-being and protects the business. We can provide guidance on tax implications and collaborate with you and your legal counsel to structure the arrangement in a beneficial manner. Ultimately, a well-defined succession plan can safeguard the enterprise you have diligently built.
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Selling Your Business: A Guide to Effective Succession Planning
Marrying Estate and Family Business Succession Planning
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Cheryl has extensive experience working with business owners and individuals on minimizing taxes, with a focus on succession planning. With a thoughtful approach, Cheryl helps clients explore their long-term goals and plan accordingly. Leveraging Cheryl’s expertise in this area, the goal is to implement plans that achieve the wishes of the client and provide for tax-efficient transitions. Cheryl’s passion for working with corporations and individuals has allowed her to become a trusted business advisor. She has worked with clients not only in the Western New York region but also throughout the country. The breadth of this experience has allowed her to collaborate with other professional advisors to ensure that plans are flexible and innovative in the ever-changing world in which we live. Cheryl started her career with the Firm in 1991 and rejoined in 2019 adding additional strength to the tremendous talent of the Lumsden McCormick tax team.