One of the most common questions we hear from our small business owner clients is what to do with their business when they want to retire. Most business owners understand that how a sale is structured can have a substantial impact on their financial picture, especially when it comes to taxes, but not as many understand that who the business is sold to can play an important role as well.
The sale of ownership equity in a business (such as shares in a corporation or membership interests in an LLC) is generally taxed at both the state and federal level as capital gains. For example, in the sale of the stock of a corporation creating a long-term capital gain of $1 million, the owner may pay $200,000-$250,000 in federal capital gains taxes and between $50,000 and $60,000 in state capital gains taxes. That’s over a quarter of the total sale price.
However, Wisconsin has a little-known exemption that applies when a business is sold to a family member. In Wisconsin, when business assets are sold by one “related person” to another, the amount received by the seller is exempt from state capital gains tax. The exemption exists to make it easier for small business owners to pass-on their family business.
For the exemption to apply,
- The assets must have been held for at least one year.
- The assets must be assets of the business.
- The sale must be to someone related to the seller within a “3rd degree of kinship,” whether by blood, marriage or adoption.
- The sale must be directly to the relative(s), not to a business owned by him or her.
- The sale must be by the owner(s), not of assets owned by the business. Most often this is in the form of sale of ownership of the business itself.
Eligible relatives include children, parents, siblings, grandparents, grandchildren, great grandchildren, nieces/nephews and aunt/uncles. Because the exemption applies to relatives related by blood, marriage or adoption, it also includes, for example, adopted children and grandchildren, brothers/sisters-in-law, adopted nieces/nephews, and stepsiblings.
If the assets being sold are shares of a corporation, a few additional requirements apply:
- There must be 15 or fewer shareholders (this is meant for small businesses after all).
- There must be no more than 2 share classes.
- The shares must all be held by people and not other entities.
This exemption comes with some strings for the buyer too. Mainly, he or she must hold the assets for at least two years before they are sold or otherwise disposed of. Failure to do so can result in a tax penalty for the buyer equal to the amount of tax that would’ve been owed by the seller had the sale been to a non-relative, multiplied by that portion short of 2 years in which the sale or disposition by the buyer is made.
While this exemption can be very valuable in the right situation, as important as knowing it exists is knowing whether and when the exemption is a good fit. We recently helped a client buy his uncle’s business where the tax implications of the sale, including that it was a sale “within the family” played a key role. While on first impression the exemption looked to be a perfect fit, ultimately the parties did not utilize this exemption, instead structuring the deal in a way that resulted in a similar total tax bill for the seller while fitting the buyer’s goals and structure.
Helping people plan what to do with their family business is at the very heart of what we at Neider & Boucher do. Whether it’s our business practice group or our estate planning team, we help business owners evaluate and plan how to pass on their businesses in a manner that meets their individual needs and goals.
This article does not constitute legal advice. Please consult legal counsel to determine how this information applies to any specific situation. If you have questions about the sale of your business or about how to buy a business, please contact John Rather at Neider & Boucher S.C. at 608-661-4500.