BY PHIL SHETSEN
Welcome back! In the previous article of this series (March 2025 issue), we talked about the importance of getting a solid business valuation and putting together a well-thought-out buy-sell agreement. These steps are key to ensuring your business thrives beyond your tenure and serve as a meaningful way to build your legacy while transferring wealth. Now, let’s dive into the next big piece of the puzzle: transitioning a business from one generation to the next.
Transitioning Ownership: No “One-Size-Fits-All” Solution
Handing over the reins to the next generation isn’t something you can do overnight. It takes years of planning, preparation, and a good balance between the financial nuts and bolts and the emotions involved among all players. Whether you’re passing ownership through inheritance or selling it outright, you’ll need to think about a few key things:
❱ How the transition impacts your finances
❱ Whether your successors are ready to take over
❱ How to treat heirs fairly—especially if some are involved in the business
Key Factors to Consider in Transition Planning
Before we get into the “how,” let’s talk about some critical factors that can shape your transition strategy.
1. Asset Sale vs. Stock Purchase
❱ Asset sale: Here, the buyer picks and chooses specific assets (like equipment, inventory, or IP) instead of buying the entire business. This is usually better for buyers tax-wise but less favorable for sellers.
❱ Stock purchase: The buyer takes over the company’s shares, including all its assets and liabilities. It’s simpler but requires careful planning.
2. Methods of Business Valuation
How do you determine what your business is worth? There are a few common ways:
❱ Book value: Essentially, this is assets minus liabilities on your balance sheet.
❱ Discounted cash flows (DCF): This looks at future cash flow and calculates its value today—a forward-looking approach.
❱ Comparable sales: This measure benchmarks your business’s value against similar companies recently sold.
3. Cost Basis Considerations
❱ Inheritance: When heirs inherit a business, its value gets adjusted to the current market value, reducing future capital gains taxes if they sell.
❱ Gifting: If you gift the business, your heirs inherit your original cost basis, which might mean higher taxes later on.
Methods of Business Transition
Now that we’ve covered the foundational factors, let’s explore some common ways to transfer ownership—and their pros and cons.
1. Inheritance by Death
❱ How it works: The business passes to heirs through your estate, usually via a will or trust.
❱ Pros: Heirs benefit from a stepped-up cost basis, reducing future taxes. The process is legally clear.
❱ Cons: Heirs might have to wait decades for ownership, and estate taxes could apply.
❱ Preparation tip: Get your heirs involved in the business early so they’re ready when the time comes.
2. Gifting the Business
❱ How it works: You transfer partial or full ownership to your heirs during your lifetime, using annual gift exclusions and lifetime exemptions to minimize taxes.
❱ Pros: Ownership transitions gradually, giving heirs time to learn the ropes. It also reduces your taxable estate.
❱ Cons: The original cost basis transfers too, which could mean hefty taxes down the road.
❱ Preparation tip: Create a plan that includes mentorship, training, and operational exposure for your heirs.
3. Creating a Transaction or Sale
❱ How it works: You sell the business to your heirs—at market value, a discount, or through installment payments.
❱ Pros: Gives you liquidity and helps heirs gain ownership through effort.
❱ Cons: Capital gains taxes might hit you, and your heirs may need financing, which could strain business cash flow.
❱ Preparation tip: Start early with financial planning and make sure your heirs have the managerial skills they’ll need to run the business.
Balancing the Needs of All Heirs
When some heirs are involved in the business and others aren’t, things can get tricky. Here are a few ways to ensure fairness:
❱ Life insurance: This can be used for your benefit to provide cash payouts to heirs not involved in the business.
❱ Trusts: A trust can allocate business interests while maintaining continuity and oversight.
❱ Dividing ownership: Split voting and non-voting shares so non-involved heirs can benefit financially without interfering in operations.
Conclusion
Passing your business to the next generation is a huge undertaking and should be carefully planned so you can make it a success. By navigating tax implications, preparing your successors, and addressing the needs of all heirs, you’ll build a legacy that lasts.
In the next and final article in this series, I’ll tackle how to handle disputes and legal challenges that might arise during the process, keeping things smooth and fair for everyone involved. [CD0425]
Phil Shetsen is the president of Bona Vita Benefits. He can be reached at phil.shetsen@prudential.com.