When it’s time to transfer ownership within a company, the CFO (with help from outside professionals in the ownership transition field) is often tasked with analyzing possible courses of action that minimize taxes and reduce the amount of risk in the transaction for both parties.

A successful insider transfer – the sale of a company to key employees (who may also be family members) usually over a predetermined number of years – has two key requirements:

1. The insiders must be willing to take on the risks of being an owner, which may involve personally guaranteeing bonding lines, bank loans, leases, and other business obligations; and
2. The plan must incentivize the insiders to grow company cash flow to fund the transfer. This “new” cash flow – not existing cash flow – will provide for the owner’s exit. This is because key employees typically don’t have the money to do so, and they cannot borrow funds to cash out the owner.

Double Taxation Dilemma

When planning for an insider transfer with a pass-through entity (S corporation or LLC ), selling stock is not the only way for an owner to acquire the after-tax proceeds from the company in order to retire. Not only is this notion a fallacy, but it is also highly tax inefficient.

With a sale of stock to the insider group (i.e., key employees) in a pass-through entity, most of the money to fund the stock purchase will come from company profits, which will first be subject to ordinary tax rates (assume a combined federal and state rate of 35%). Then, that money will be paid to the selling shareholder for his or her shares, where it is again taxed at the capital gains rate of 20%. Due to this double taxation, close to 50% of the available cash flow and profits to fund the owner’s exit plan could be lost to taxes.

Two-Step Exit Plan

Many owners often don’t realize that after-tax profits can be received from a number of different sources – not just the proceeds from the sale of their stock.

Further, a successful exit strategy should focus on having the insiders grow the company’s cash flow quickly enough to help the owner exit on the desired date with the money he or she needs.

To achieve this, many exit planners use a two-step process that minimizes taxes and reduces risk on insider transfers. In this process, a sale of stock at market value (the lowest defensible value) is combined with direct payments (such as deferred compensation or S corporation or LLC distributions).1

If company cash flow is a source of payments to the owner, having it taxed only once enables the owner to quickly get what he or she needs with less risk to the business.