Preface: Transfers of business interests should be well-planned. This blog provides a precis of planning a transfer of ownership hypothetically for less than fair market value. What can it look like?

 

Planning Transfers of Family Business Interests for Below Market Value

After years of building your business, maybe you’re working to retire and let family control your ownership? If you are transferring a business interest to family or a key-person, you should understand the appropriate steps in a well-planned transfer of interest with a transition advisor, business appraiser, tax accountant and attorney. This blog is to highlight for business owners an appropriate planning precis of a business transfer.

For sake of conversation let’s say alias Delmar has an electrical business, Lancaster ProElectric with revenues in-excess of $3,000,000 per annum, with three family members who work in the business with him. Let’s say Delmar owns 100% of the S-Corporation. Delmar thinks he should retire and transfer the business to three family members.

The first step in the transfer should be for Delmar to contact a transition advisor to provide counsel and oversight, to along with facilitating the transfer, retain value before, during and after the interest transfer. A transition advisor can help Delmar develop expectations, i.e. new key-person expertise in the business, and provide objective counsel to the transition. Working together with the transition advisor, Lancaster ProElectric could next obtain an appraisal of the marketplace business value. This is a valuation of assets, cash flows, and say goodwill that can consider relative value calculators e.g. key persons – Lancaster ProElectric may have experienced technicians, or a project manager, with signature project experience that permits Lancaster ProElectric to competitively bid on a variety of projects.

An appraisal of the business should be obtained for purposes of properly valuing the business. Often times, these transfers among family members occur at less than fair market value, and require a gift tax return to be filed. To verify the business marketplace value, you need a qualified appraisal. With the business appraisal in hand, Delmar can then work with his transition advisor to implement the ownership transfers. Let’s say the decision is to transfer 90% of the business in three 30% ownership units, with Delmar retaining a 10% interests in Lancaster ProElectric.

Let’s say the comprehensive business appraisal is $1,750,000. Delmar decides that he will sell each 30% interest of stock for $275,000. Since fair market value is $525,000, Delmar has a gift of $250,000 to each of the three family member’s purchase of stock. The difference between marketplace value and sale value requires gift tax returns to be filed. If Delmar skips that business appraisal, and sells each 30% interest for $275,000, without proper transfer guidance, in an IRS audit, he will be subject to an IRS valuators appraisal of the business. That appraisal could be substantially higher than that of an independent valuator, reducing his gift exclusion on future transfers of accumulated estate, not to mention IRS hassles.

For transfer and sale of stock, Delmar will involve his attorney to prepare share purchase agreements for the stock sale, Promissory notes for the $275,000 of stock purchases, collateral and restriction terms on stock sale, and adjustment of stock certificates, i.e. the certificate ledger. A well planned transfer of a business interest will provide seamless continuity, and help preserve internal cultures and marketplace performance expectations.

Summary: A transfer of a business interest should be well-planned with a team of advisors each contributing specific performance expertise, e.g. transition counsel, business appraiser, accountant, attorney. If you are thinking of transferring your business in the next five years, for optimization with the involved members, begin preparing [planning] per for that transition today.