Business owners sometimes want (or need) to buy out a business partner. When that happens, there are many potential pitfalls. One of the most important things you can do is to ensure you understand the tax implications before you draw up a contract and complete the transaction.
At CMP, many of our clients own businesses, and the subject of buyouts comes up a lot. Whether you’re considering a buyout now or think you may have one in your future, we’ve created this guide to help you wrap your head around the tax implications and ensure you’re protected.
What is a Business Partner Buyout?
A business partner buyout is a transaction that occurs when one person in a business partnership wants to get out of the business. When that happens, the partners have options. One is to sell the business to a third party and divide the proceeds between them. The other is for one party to buy out the other.
Said another way, a business partner buyout is a process by which one partner can purchase the other partner’s interest in the business and take sole control of the business. You’ll need an independent valuation of your business and advice from a tax professional to avoid overpaying on taxes.
Common Reasons for Buying Out a Business Partner
There are three primary reasons that may initiate a buyout. Here are the things that can make a buyout necessary:
- One partner wants to retire or move on. If a partner is ready to retire or has simply lost interest in the business, they may ask their partner if they would be willing to buy them out. This is common when succession planning.
- One partner needs to recoup the money they put into the business. Financial circumstances may sometimes make a buyout advantageous to one partner, and they may ask the other partner to buy them out so they can access the money they invested.
- The partners decide they can no longer work together. Every partnership has its challenges, and it may be that business partners come to a parting of ways when they realize they can no longer work well together. In such cases, one partner may choose to buy the other out.
If done properly, a buyout can be advantageous to both partners.
When considering buying out a business partner, it's essential to have a clear understanding of the process and implications. To make informed decisions, you should explore the questions to ask when buying a small business. Knowing these key questions can help you navigate the buyout smoothly and ensure a beneficial outcome for both parties involved.
Types of Business Partner Buyouts
Business partner buyouts may take several forms depending upon the financial circumstances of the partners and their ability to qualify for financing. Here are four of the most common options:
Self-Funding
Self-funding is the least complicated option for a business partner buyout, where the buying partner uses their own money to pay for the buyout. Self-funding may be either a lump-sum buyout or an installment plan, where the two partners agree to divide the payment, and the purchasing partner makes regular payments until their financial obligation is met and the buyout is complete.
Equity Financing
Equity financing happens when a business raises money for a buyout by selling shares. Shares are sold to one or two angel investors or may be made available to the general public. The most common use of equity financing is when the partner selling their share of the business has a unique skill that must be replaced for the business to thrive.
Debt Financing
As its name suggests, debt financing is when the partner on the purchase end of the buyout takes out a loan to pay for the buyout. It may also apply to a self-funded installment plan because the payments represent a form of debt.
Earnouts
An earnout occurs when the selling partner agrees to stay with the company to help maintain its financial stability and earnings. An earnout may allow the selling partner to earn more money and ease the transition to a new leadership team or partner.
What Are the Tax Implications of Buying Out a Business Partner?
There are some important tax implications to know before you buy out a business partner.
How Does the IRS Classify Buyout Payments?
If you make installment payments to buy out a partner, those payments are classified in one of two ways:
- Section 736(a) payments are guaranteed payments to an exiting partner. They are tax deductible for the business and taxed as ordinary income for the recipient.
- Section 736(b); payments are payments for the departing partner’s share of the business assets and are not tax deductible for the business. The exiting party must report the difference between 736(b) payments and their tax basis in the business interest as capital gains and not ordinary income.
Section 736(a) payments are more advantageous for the business, while 736(b) payments are more advantageous for the exiting partner.
Hot Assets
When one partner purchases the other’s share of business assets, one question that must be addressed is whether the assets are “hot” or not. The IRS defines a hot asset as any asset that may generate income over time, including unsold inventory and unrealized receivables.
If your buyout includes hot assets as part of the exiting partner’s distribution, then that part of the distribution will be recorded and taxed as ordinary income.
Tax Treatment of Goodwill in a Buyout
Any established business has acquired some amount of goodwill, by which we mean the value of its brand, reputation, loyal customer base, and proprietary technology or processes.
Goodwill adds to the value of a business, ultimately increasing its purchase price. Because goodwill is an asset, the exiting partner must be paid for their share of it.
For taxation purposes, goodwill is governed by how it is defined in the partnership agreement or operating agreement of the company. It may be classified as Section 736(a) or 736(b) payments, as indicated above.
How to Minimize Tax Liability in a Business Partner Buyout
There are several ways to minimize tax liability on both sides of a buyout. Here are a few tips to help you minimize your tax payments on the sale.
- Choose an installment plan. While getting paid in installments can reduce the amount of tax you pay while spreading the payments out over time.
- Structure the buyout properly. As a buyer, it’s preferable to buy depreciable assets instead of stock, but sellers should push for a stock sale because it results in lower taxes.
- Sell a partnership interest. If you sell a partnership interest, it will be treated as a capital asset transaction and taxed as capital gains instead of ordinary income.
These tips can help you minimize your taxes after a business buyout.
The Impact of Buyouts on Business Valuation
In some cases, a business buyout can have an impact on the value of the business. The most common issue is when the exiting partner is also responsible for most of the company’s goodwill. For example, if the person selling is the public face of the business or if their expertise is responsible for a lot of goodwill, the business valuation may drop after the buyout.
Consider structuring the buyout as an earnout and asking the exiting partner to stay on for a while to ease the transition, particularly if you have the opportunity to bring someone into the business who has the potential to minimize the loss of goodwill.
Financing the Buyout
There are several ways to finance a business buyout.
- Self-funding. If you have enough liquidity, you can finance the business buyout yourself without help from anybody else.
- Equity financing. You could get money by selling an equity stake to an outside investor to help you buy your partner out.
- Bank loan. Some business owners may qualify for a traditional bank loan to finance a buyout.
- SBA loan. If you qualify for an SBA loan, you can use the funds to buy out your partner.
- Bridge loan. A bridge loan may be an option for some but be aware that these are short-term loans, and you’ll pay an additional closing fee if you need to refinance it into a longer-term loan.
We suggest talking to a professional before choosing a financing option since your choice can have long-term financial implications for your business.
The Role of a Professional Tax Advisor in a Business Partner Buyout
Working with a tax professional during a business partner buyout makes sense for partners on both sides of the transaction. A buyout can impact your taxes and the financial health of the business, so it’s necessary to get advice and guidance before you proceed.
CMP has years of experience guiding business owners through buyouts, and we’re here to help you navigate the process while minimizing your tax liability.
The Tax Implications of a Business Partner Buyout Can Be Complex
Buying out a business partner requires careful preparation if you want to avoid paying unnecessary taxes. The guidance we’ve provided here can help you avoid some of the most common pitfalls and have a successful buyout.
Do you need assistance with a business partner buyout? CMP is here to help with everything from business valuation to tax planning services. Contact us to schedule a free consultation today.
