As a small business owner growing older, you look forward to retirement and transferring the business to the next generation. An estate freeze is a classic transfer technique that allows you to get a fair value for the business while retaining some control over the decision-making process during the transition period. For the next generation, it’s a way to acquire the business without incurring massive debt. So how does it work?
How an Estate Freeze Works
The first step is to value the business. In some cases, that is a fairly simple process, in others, you may need to retain the services of a professional. For tax authorities to accept the estate freeze transactions, the transaction is paid at fair market value.
As a rule of thumb, the fair market value is the price that a reasonably interested buyer would pay to a reasonably interested seller. After determining the value of the business, you convert the current common shares, owned by you — the founder— into preferred shares with the right of redemption before any other shares. In this way, any capital —profit — that comes out of the company goes to these shares.
For example, if the value of your company is $1 million, the preferred shares receive the first million dollars of capital.
All of the company’s value freezes at that precise moment for the preferred shares. Your business then issues new common shares to the next generation of the family for a nominal consideration. In this way, the next generation benefits from all future growth.
There are variations of this technique that use holding companies, family trusts, and multiple types of shares. It’s a good idea to consult a tax professional to determine what works best for your particular situation.
Freezing the value of the company is only a first step towards retirement for you as the founder or owner of a company. Cashing out on the value of the shares is also important. It’s beneficial for you to put a plan in place to buy out the preferred shares gradually.
In the example above, a new owner or your next generation family owners buy your shares over a period of 10 years, at $100,000 a year, with or without an interest component.
Families often agree to use a set percentage of the annual profits, for example, 50%, to make sure that the new buyers have enough cash flow to prosper. At the same time, you want to retain some form of control over the decision-making process until you receive payments for all of your shares. You can achieve this through multiple voting shares, a shareholder’s agreement, or a will.
Passing on a family business is always a challenge, but using an estate freeze is a great way to begin the process and ensure that it is fair for all involved. Keeping up with your current finances is the key to providing future generations with a profitable business. QuickBooks Self-Employed app helps freelancers, contractors, and sole proprietors track and manage business on the go. Download the app.