There is a tax-advantaged strategy that can make a sale viable to insiders — one that is not available for sales to an outside third party. Though most small businesses tend to transfer internally to family members or key employees, says consultant Ken Stiefler, president of Exits in Denver, “many [sales] don’t even work internally because the insiders don’t have money."
The standard sale method is to have the inside buyer sign an installment note for the full value of the company. This typically takes nine or more years and has substantial risks for both the buyer and the seller. The tax-advantaged method, Stiefler says, is a two-step approach that starts with the owner receiving part of the value of his/her ownership interest from tax-deductible payments that come directly from the company (deferred compensation, salary continuation) and the balance by selling his or her shares to the insider.
Step 1: Sell a minority interest to the insider at a substantial discount — typically 35% to 40%. This discount is recognized by the IRS because of what is referred to as a “lack of control” and also a “lack of marketability” of this ownership interest by the minority shareholder. This is because the new owner does not have full control of the business and cannot sell his or her portion of the ownership to anyone else. Stiefler says that the company has to be properly valued by valuation specialists for this strategy to work. “The S-corporation distributions are enough to pay for that minority interest that they are purchasing with the 35% to 40% discount,” he says.
Step 2: Once this minority interest is completed, the balance (now a controlling interest) can be sold to the insider, typically at full value, Stiefler says. This final sale can often be bank-financed by the buyer using his/her fully paid minority interest as collateral. The result is a transfer that can be accomplished in three to four years versus nine-plus years, Stiefler says. —Nina Patel is a senior editor at REMODELING. Find her on Twitter at @SilverNina or @RemodelingMag.
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