Five Ways to Extract the Equity In Your Business

Five Ways to Extract the Equity In Your Business

If you own a small business, chances are you expect to use the equity you’ve built up over the years to fund all or part of your retirement. At the same time, you may want to pass on ownership of the business to your family to ensure that they can benefit from it beyond your lifetime. First and foremost of course is the need to leave the business in good hands. Once you have identified someone qualified to run it, whether a family member or not, your next step should be to get an accurate valuation of its worth. That’s essential for determining not just a possible sale price but ultimately how much retirement income you might be able to get from a transfer.

Once you’ve figured out all the above, it might be tempting to sell the business outright to a family member or even a third party.   Be aware, though that the tax consequences can be significant, not to mention complex. Certain elements of the business may be taxed at capital gains rates while others might face ordinary income marginal rates. If the business includes buildings or other physical assets, depreciation recapture may come into play. And receiving the entire valuation as income in a single year will maximize the tax hit.

The alternative is to structure the transfer in a manner that provides you sufficient retirement income but spreads it out over time in order to reduce the total taxes owed. At the same time you should be thinking about maximizing the wealth you pass on to your heirs by minimizing your estate taxes. With these goals in mind, here are a few approaches you might consider:

  • If you own an office building or other physical assets, you could sell the business but retain those assets and lease or rent them back to the company. This would reduce the overall value of the sale (and your consequent income taxes), plus provide you with an annual income stream during retirement. Such arrangements should be agreed upon beforehand and spelled out clearly in the sale agreement. The disadvantage is that should the company go bankrupt at some point in the future, you’d be forced to find another lessee or a buyer for those assets, a hassle you might not want to have to deal with after you’re retired.
  • Utilize a grantor retained annuity trust (GRAT) or a grantor retained unitrust (GRUT). These are irrevocable trusts to which you transfer company stock or other business assets for the purpose of receiving income over a fixed period of time. A GRAT provides fixed periodic payments while a GRUT provides payments based on a fixed percentage of trust assets that is revalued annually. At the end of the payment period (or if you should die before that time) the assets in the trust – your share of the business – pass to your children or to whomever you’ve named as the trust beneficiaries. And the value of the distribution will be reduced by the amount of interest paid to you, typically resulting in lower estate or gift taxes.
  • Create a private annuity. This involves transferring complete ownership of the business to family members or to another party (the buyer). The buyer in turn makes an unsecured promise to make periodic payments to you for the rest of your life (a single life annuity) or to you and to your spouse if he/she should outlive you (a joint and survivor annuity). Because a private annuity is a sale and not a gift, it allows you to remove assets from your estate without incurring gift tax or estate tax. On the downside, since the commitment to pay is unsecured, your income stream is at risk if the buyer fails to continue the payments. Furthermore, tax laws regarding the deferral of capital gains taxes when exchanging property for unsecured private annuities have been changing, making this option one for which you should definitely seek professional tax advice.
  • Utilize a self-canceling installment note (SCIN) that allows you to transfer the business to the buyer in exchange for a promissory note committing the buyer to make a series of payments to you. A provision in the note states that at your death, the remaining payments will be canceled. A SCIN provides a lifetime income stream and avoidance of gift tax and estate tax similar to private annuities. Unlike private annuities, with a SCIN you retain a security interest in the transferred business, giving you more options (and consequently lessening the risk) in cases of non-payment.
  • Create a family limited partnership (FLP) with both general and limited partnership interest shares. You transfer the business to the FLP while retaining the general partnership shares for yourself, allowing you to maintain control over the day-to-day operation of the business. Over time, you gift the limited partnership shares to family members. For tax purposes you can discount the value of the gifted shares on the grounds that they represent a minority interest in the business and also due to lack of marketability. This may enable you to successfully transfer much of your business to your heirs at significant transfer tax savings.

If you expect your business to outlast you and you want you and your family to benefit from all the hard work you put into building it, it’s most important to come up with a plan to do so well in advance of your retirement date. Be sure to involve your financial planner, tax professional, and business or estate attorney as well.

 

 

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