An owner has several options for transferring ownership in a partnership or LLC. Many owners depend on business cash flow to meet their living expenses. These owners generally must choose a transfer option that generates enough liquidity (either when the transfer occurs or afterwards) to meet their income needs.
1. Selling or Liquidating an Interest
Clearly, selling or liquidating a partnership interest and selling assets provide liquidity. However, business owners often are forced to finance at least part of the sale, so some payments to the owner may be deferred.
2. Gifting an Interest
Gifting will not create liquidity for the owner and may actually cause a cash outflow if gift tax is incurred. For an owner with liquidity concerns, annual exclusion gifts may be used, since they do not trigger gift tax, but to the extent an interest is gifted, the owner reduces his net worth, since no consideration is received in exchange.
3. Compensatory Transfers
Compensatory transfers of an unrestricted partnership interest in connection with performing services triggers immediate taxable income for the recipient equal to the fair market value (FMV) of the interest received, reduced by the amount paid, if any. These transfers do not result in any proceeds to the owner, but may indirectly provide liquidity because the partners receive a tax benefit if the value of the compensation is deductible.
A spin-off by itself does not generate or cost the owner any cash. However, if the intended successors do not already own an interest in the business, the owner will have to use another transfer technique (e.g., gifting or selling part of the partnership interest) to get the interest in the spun-off partnership into the successor’s hands.
Minimizing Current Tax Liability
Absent mitigating factors, business owners usually prefer an exit strategy that minimizes and/or defers taxes incurred on the transfer. The ability to minimize taxes will be affected by the transfer method and the tax basis and FMV of the property transferred. Because business interests often are highly appreciated, the tax cost of transferring them can be significant. Deferring payment of any income tax liability likely will depend on the owner’s willingness to accept deferred payment of the sales proceeds.
Selling or Liquidating an Interest versus Selling Assets
Generally, it is fairly easy to compare the results of a sale of a partnership interest, a liquidation of the interest or an asset sale followed by a complete liquidation. Assuming a cash sale, the sale of a partnership interest and a liquidation generally produce the same tax liability since the owner is effectively selling the interest in both cases.
A properly structured partnership spin-off generally does not create a current income tax liability as long as the owners of the new entity own an interest in the partnership before the spin-off. However, if the successors do not currently own an interest in the existing partnership, the owner may have to transfer ownership in the existing partnership to create an ownership structure that will facilitate the spin-off.
The ability to minimize taxes on a transfer by gift depends on the value of the interest transferred and the availability of the owner’s applicable exclusion amount for lifetime gifts to offset the transferred amount. However, valuation discounts may reduce the transferred value and help minimize the liability. While annual exclusion gifts are gift tax-free, the relatively modest annual exclusion limit restricts the ability to transfer significant amounts of value that way.
Reducing the Owner’s Taxable Estate
For many business owners, planning to avoid or minimize estate tax is a critical component of the exit strategy. Because many owners’ estates are fairly illiquid minimizing estate taxes is critical to ensuring the estate and heirs have sufficient cash to avoid a forced sale of the business. Transferring a sufficient interest during the owner’s lifetime to reduce his holdings at death to a minority interest results in the interest held at death being valued net of a discount for a minority interest. This is true regardless of the transfer technique chosen, but of course, depends on the owner’s ability to give up a controlling interest.
Gifting an Interest
An outright gift of a partnership interest to the successor best accomplishes the goal of reducing the taxable estate. A gift removes the value of that interest, plus any future appreciation from the owner’s taxable estate. In addition, any gift tax paid on the transfer is also removed from the estate. Of course, owners hesitate for various reasons to gift large interests to their successors. Gifts to properly structured trusts can remove the same amount of value from the estate and place the assets under a trustee’s management.
Selling or Liquidating an Interest
Selling a partnership interest or liquidating the interest has the same effect on the owner’s taxable estate. These transfers result in removing the future appreciation in the value of the interest from the owner’s estate. The business’s value at the sale or liquidation date is merely converted to another asset (e.g., cash, property, or notes receivable). Unless expended before death, that asset is included in the owner’s taxable estate. Similar to a gift, the owner’s estate is also reduced by any income tax paid on sale or liquidation gains.
A spin-off should not have any material effect on the owner’s taxable estate. In a spin-off, the owner’s percentage interest in the value of the business is unchanged. Instead, the transaction merely reshuffles the business assets (and value) between different partnership entities. Of course, it may be necessary to use another transfer option (e.g., a sale or gift) to give the successor an ownership interest in the spun-off business.
Minimizing the Successor’s Exposure to Acquired Liabilities
The successor’s exposure to business liabilities is one of the most critical negotiating points when a business is sold. An owner willing to use a transfer option that insulates the successor from business liabilities is usually able to demand a higher price for the business. Of course, to the extent liabilities are not transferred to the successor, they will remain the owner’s responsibility.
Selling assets to the successor is the only way to shield him from most business liabilities. When the business owner needs consideration from the transfer and no purchaser is willing to acquire a partnership interest, an asset sale is sometimes the only way to accomplish a sale.
Avoiding Transaction Costs and Complexity
Every transfer option has a cost, both in terms of money and in the amount of effort required. Often, the beneficial results of tax planning are not apparent until many years later. Some owners are more willing than others to incur current costs for a future benefit.
Selling a partnership interest is usually much simpler than selling assets. Transferring ownership in real property can be fairly expensive, since a title search and title insurance are generally required if a lender is involved. Other expenses, such as recording deeds and attorney’s fees are usually incurred with real estate sales. Likewise, transferring title on a large number of vehicles can be time-consuming and costly. If intangible assets such as trademarks are sold, it is usually necessary to perform some research to ensure that the intangible can legally be transferred. All these costs are avoided when a partnership interest is sold, since the owner of the assets (i.e., the partnership) remains the same.
Ability to Complete the Transfer Quickly
Obviously, the sooner an owner begins planning his exit strategy and acting on the plan, the longer he has to accomplish the transfer. In reality many owners delay planning, and wait until they are 60 or even 70 years old to begin. These owners generally are limited to transfers that can be accomplished relatively quickly.
A gift generally can be accomplished quickly, but to avoid or minimize gift tax, many owners prefer to use annual exclusion gifts. The longer time period over which such gifts can be made, the more value can be transferred free of gift tax. An owner who is advanced in age will not be able to derive much benefit from annual exclusion gifts.
When comparing sales options, selling a business interest is usually less complex and therefore accomplished quicker than an asset sale. The length of time needed to complete an asset sale depends on the number and nature of assets sold.
A liquidation of the owner’s interest can usually be completed fairly quickly, assuming no state law restrictions exist. However, if the successors are not already owners, they will have to obtain some ownership interest before the liquidation takes place in order for the liquidation to result in the desired ownership transfer.
Due to the complexity, a spin-off may require a substantial amount of time to complete. To avoid a taxable gift, the value of any interest received in the spin-off must equal the value of the interest given up. Thus, some realignment of ownership before the spin-off may be necessary.