Benefits and Strategies for Transferring Ownership to an Insider

I’ve recently had several clients successfully exit their businesses by transferring to a family member or key employee. Is transferring to an insider a consideration for you? The benefits are many.

Most important is that this choice gives you a great deal of control over the exit process and therefore your ability to define your exit terms and achieve the exit objectives you identify. Transferring ownership to insiders makes you the banker, reduces risk, and can increase the amount of money you walk away with. This choice also helps maintain the stability of your company. Rather than creating concern among and potential loss of key employees, the insider-transfer option will typically reassure, motivate, and retain key employees. When you remain a part of the process, it becomes seamless and reduces risk to your company and everyone involved.

If you plan to transfer to an insider, have you identified the family member(s) or key employee(s) to whom you’ll entrust your company? If not, consider these key points to help choose your successor.

  • He/she has a direct and significant impact on the value of the business
  • His/her combination of skills and experience would be difficult to replace
  • He/she will participate in a meaningful way in the strategic future of the company
  • Does the insider reflect the needs of the business’ future?
  • Can this person build upon what you’ve done and take the company to new heights?
  • Have you had ample time to observe this person in action?
  • What are their strengths?
  • Where are the gaps? Can they obtain the knowledge they need to fill those gaps?
  • What else should you consider that’s unique to your business?

Once you’ve chosen your insider, it’s time to consider your options for transferring your business.

First, you’ll need a business valuation report for your company. For context, here are what I refer to as the three levels of valuation reporting and what each provides:

  • “Cadillac” – Full-blown report on valuator’s letterhead which meets IRS guidelines
  • “Oldsmobile” – Less complex report with scope restrictions on valuator’s letterhead
  • “Chevrolet” – Worksheet version with baseline

Next, you’ll choose one of six common transition-to-insiders strategies. Here is a list, with the pros and cons of each:

1. Bequeath the Ownership

This is the only transfer strategy that cannot be completed during your lifetime. It is the simplest choice and easiest to accomplish – you need only amend your Last Will and Testament. There are some considerations, however. This transition requires the more complex, and therefore more expensive, “Cadillac” business valuation. In addition, your estate receives no monetary payment for the value of your company.

2. Gift the Ownership

This transfer of ownership is typically accompanied by a deferred compensation agreement to the donor and/or the donor’s spouse. Drawbacks are the same as those associated with bequeathing ownership – it will likely require a “Cadillac” business valuation and there is no payment to your estate for the value of your company. In addition, there is no step-up in basis on the price of units for those who receive the gift of ownership.

3. Sell the Ownership Units

If you choose this route, you are no longer in charge of the company. To facilitate this transfer however, it may be necessary for you to finance the sale. So, you will still be attached to the success of the company, but with no authority – thereby assuming all the risks but reaping no rewards. In addition, there is a step-up in basis to the price of ownership units.

4. Bonus the Ownership

Advantages associated with this method of transfer are that the company will grow in value, there is a cash payout, and you deal with only one level of taxation. When you bonus ownership to key employees, they should be required to earn ownership based on metrics you establish in advance. Be aware that if you choose this route an annual valuation will be required, but just the more basic “Chevrolet” report.

5. The “Popeye” Plan

This plan requires that you are able to document ten years of consistent earnings. The value of the company is converted to cash on a regular basis and distributed, making the business cash poor. Those who acquire the stock will have little basis in it. Benefits to you are that, over the life of this plan, you draw all the accumulated equity and there are no valuation costs.

6. “Oldco/Newco” Plan

Creating an entirely new company is also an option. This strategy can be both complicated and costly in that you will be maintaining two companies. And you may be subjected to greater scrutiny by the IRS. There are no valuation costs, however.

The process of transferring to an insider can range from relatively simple to quite complex. But there is a strategy to successfully carry out each option. Planning is the key to writing your own future. For help choosing the transfer strategy that is right for you, contact me or visit my website for an overview of exit planning or to access our assessments and resources.

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