Small Business Questions
By: Financial Hotline
Spring 2024 (Vol. 42, No. 1)
Q: I have a small business that my wife and I run. We are starting to consider retirement and we have family members interested in taking over. What are some things to consider when we start these discussions?
A: Transferring a family business successfully requires careful planning and clear communication. You will need to determine what the business is worth and how you will want to be compensated. For example, will you want a lump sum payment or do you need monthly income? Will you retain percentage ownership or transfer it in full?
How the business will transfer depends on its structure. If your small family business is a sole proprietorship, you could transfer business ownership by selling its assets. If it’s a partnership, you could transfer your interest to other partners. If it’s a corporation, you can transfer by gifting, selling, or bequeathing shares.
It’s important to define in writing exactly what will happen with target dates and goals. Here are four main points to consider:
1. A business strategic plan. This defines goals, objectives, and targets for a company and outlines the resources that will be allocated to achieve them. When a strategic business plan is in place, it allows each generation an opportunity to chart a course for the firm. Setting business goals as a family will ensure that everyone has a clear picture of the company’s future. A strategic plan is long-term in nature and focuses on where you want the business to be at some future date.
2. A family strategic plan. This plan establishes policies for the family’s role in the business and is needed to maintain a healthy, viable business. For example, it should include the creed or mission statement that spells out your family’s values and basic policies for the business, and it may include an entry and exit policy that outlines the criteria for working in the business. The plan should consider which family members desire to have a part in management of the business versus those who desire a more passive role.
3. An estate plan. This is a written document that outlines the disposal of your estate and includes such things as a will, trust, power of attorney, and a living will. It is essential to leave clear instructions, so your business does not fall to heirs who have opposing goals. Without a good plan in place, you may also pay higher estate taxes than necessary, allocating less of the estate to your heirs.
4. A succession plan. This is where you will identify key individuals who will be trained to take over the business when the time comes. You should also outline a precise timeline and detail how the training will be done. This plan should include introductions to key vendors and customers. Having a calendar of events and sticking to them goes a long way toward easing concerns for all involved.
Q: I own a corporation. How can I ensure the compensation I take is “reasonable” in the eyes of the IRS?
A: If you own a C corporation, you know there’s a tax advantage to taking money out as compensation rather than as dividends. The reason: A corporation can deduct the salaries and bonuses that it pays executives, but it can’t deduct dividend payments. Therefore, if funds are paid as dividends, they’re taxed twice, once to the corporation and once to the recipient. Money paid out as compensation is taxed only once, to the recipient employee.
However, the amount of money you can take out of the corporation this way is limited. Under tax law, only compensation deemed to be reasonable can be deducted. Any unreasonable portion isn’t deductible and may be taxed as if it were a dividend paid to a shareholder. There’s no simple way to determine what’s reasonable. If the IRS audits your tax return, it will examine the amount that companies in similar industries would pay for comparable services under comparable circumstances. Factors considered include the employee’s duties and the amount of time spent on those duties, as well as the employee’s skills, expertise and compensation history. Other factors that may be reviewed are the complexities of the business and its gross and net income. Here are some steps you can take to make it more likely that the compensation you earn will be considered “reasonable” and therefore deductible by your corporation:
1. Keep compensation in line with what similar businesses are paying their executives. Be sure to retain whatever evidence you find about what others are paying.
2. Contemporaneously document the reasons for compensation paid in the minutes of your corporation’s board of directors. For example, if compensation is being increased in the current year to make up for earlier years when it was low, be sure the minutes reflect this. Cite any executive compensation or industry studies that back up your compensation amounts.
3. Avoid paying compensation in direct proportion to the stock owned by the corporation’s shareholders. This can look like a disguised dividend and will probably be treated as such by the IRS.
4. Pay at least some dividends if the business is profitable. This avoids giving the impression that the corporation is trying to pay out all of its profits as compensation.
Keep in mind that the IRS is generally very interested in unreasonable compensation payments made to anyone “related” to a corporation, which may include not only a shareholder-employee but also a member of a shareholder’s family.
Q: I am closing my business. What are my final tax responsibilities?
A: The exact checklist will vary depending on the specific details of your business. But in general, the final income tax return and related forms must be filed for the year of closing. The correct return to file depends on the type of business.
Sole proprietorships.
You must file the usual Schedule C, “Profit or Loss from Business,” with your individual return for the year of closing. You may also need to report self-employment tax.
Partnerships.
A partnership must file Form 1065, “U.S. Return of Partnership Income,” for the year of closing and report capital gains and losses on Schedule D. Indicate that this is the final return and do the same on Schedules K-1, “Partner’s Share of Income, Deductions, Credits, etc.”
All corporations.
Form 966, “Corporate Dissolution or Liquidation,” must be filed if you adopt a resolution or plan to dissolve a corporation or liquidate any of its stock.
C corporations.
File Form 1120, “U.S. Corporate Income Tax Return,” for the year of closing. Report capital gains and losses on Schedule D. Indicate this is the final return.
S corporations.
File Form 1120-S, “U.S. Income Tax Return for an S Corporation” for the year of closing. Report capital gains and losses on Schedule D. The “final return” box must be checked on Schedule K-1.
All businesses.
If you sell your business, other forms may need to be filed to report the profit or loss from the sale.
Businesses with employees must pay the final wages and compensation owed, make final federal tax deposits and report employment taxes. Failure to withhold or deposit all employment taxes due can result in severe penalties. Generally, payments of $600 or more to contractors during the calendar year of closure must be reported on Form 1099-NEC, “Nonemployee Compensation.”
Depending on the size and scope of your business there may be more still to do. For example, a business that has an employee retirement plan will need to terminate the plan and distribute the benefits to participants. Flexible Spending Accounts and Health Savings Accounts must also be terminated.