4 Steps for Buying Out a Small Business Partner

Business partnerships always begin with good intentions.

Two friends, two family members, or two co-workers have a great business idea, each person brings something valuable to the table, and “Voilà!” You have yourself a business that will hopefully last a lifetime!

With partnerships, though, there will come a point in time when one of the partners decides that it’s time for a new chapter in their life.

Retirement could beckon following many prosperous years for the partnership. Or maybe one partner found a better opportunity and left the partnership on amicable terms. And then there’s the “One of us has got to go” scenario where after a great start to the partnership, the partners now can’t tolerate working with each other.

Whatever the reason, one partner being bought out by the remaining partner (or more) is a complicated transaction that can be filled with lots of emotion.

This article highlights the steps you should take when buying out a partner and all the moving parts you should be aware of before starting down this path.

Steps to buying out a business partner

Hopefully, the news that one of your business partners wishes to exit the business doesn’t come as a surprise. There should have been clues or previous discussions where you were made aware of this partner’s intention to possibly exit the partnership. When the decision to exit is officially made, be sure to establish clear lines of communication with the exiting partner to set expectations and reduce friction.

Here are several steps to consider as you begin the process of buying out your partner:

Engage with your attorney

The first step in buying out your business partner is to contact your attorney. This is especially critical if the buyout isn’t amicable. The attorney can help you to begin making sense of the necessary legal steps to execute the buyout transaction.

One of the documents your attorney can assist with is the buy-sell agreement. Hopefully, you already have a buy-sell agreement in place. This agreement defines the terms and conditions whenever a partner wants to exit and typically details the procedures for various exit scenarios, including retirement, incapacitation, and death.

The agreement also has various clauses that will dictate how the buyout transaction will occur, which valuation method will be used, payment guidelines, and right-of-first-refusal for current partners. If your business is still operating and doesn't have this agreement, consider creating one.

If you don’t have a buy-sell agreement already in place, contact your attorney to help you and your partner(s) draft an agreement as soon as possible.

Engage with your business accountant

Your business accountant plays a vital role during the buyout of a departing partner.

First, partnership accounting is one of the most complicated sections of the tax code. Your accountant can help make sense of all the tax rules that govern partnership agreements, and make sure that your business’s bookkeeping is accurate and up-to-date before the buyout transaction takes place.

Second, your accountant will help to conduct your business’s valuation in accordance with the buy-sell agreement, and then allocate the appropriate percentage to the exiting partner.

To perform the valuation, your accountant will first need to prepare a current set of financial statements — a balance sheet, an income statement, and a statement of cash flows. An important part of the financial statements during a buyout is the equity section on the balance sheet. This is the section that will ultimately determine how much money the exiting partner will receive and how the exiting partner’s share of the company is divided among the remaining partners.

Engage with your insurance agent

Life and disability insurance both play a crucial role in helping to mitigate risks during a buyout. If one of the remaining partners either dies or becomes incapacitated, the departing partner wants a guarantee that he or she will still receive the entire agreed-upon sales price of their share of the business. Consider a regular review of your insurance policies to ensure they reflect the partnership’s current value and an up-to-date list of active partners.

Determine how the buyout will be financed

You may need to borrow the required amount of money to buy out your partner. Here are several options to consider:

Self-funding. Many partnerships self-fund the exiting partner’s buyout. Using this method, the exiting partner serves as the lender who is paid over a defined period of time. If the exit is amicable and there are clear payment terms, self-funding is a great option to consider.

SBA loan. The Small Business Administration (SBA) makes certain types of loans available to help with the purchase of businesses and buyouts. One of the more popular types of loans is the 7(a) loan, designed specifically for starting or expanding by means of a strategic acquisition, such as buying out a partner.

Traditional loan. Many traditional banks shy away from financing a buyout because there’s a risk that the partnership may experience a financial downturn following a partner’s departure. If you can qualify for a traditional loan, then it’s certainly an option to consider.

Alternative loan. Alternative lenders are typically more flexible in every step of the loan process — from a short application to a funding decision that happens in days, not weeks, and quick access to funding if you are approved.

Earn-out. The exiting partner continues working for the partnership while receiving payments from the buyout. This arrangement sometimes includes a clause that increases the buyout payments if the partnership meets certain revenue and profit benchmarks.

Buyouts can be taxing

An area that is sometimes overlooked during a buyout is how the transaction is taxed. Here are some of the more important tax implications to be aware of:

Money received as a guaranteed payment — The exiting partner receives monthly payments that are similar to receiving a salary. These payments are tax-deductible to the partnership and taxed at rates up to 37% for the exiting partner.

Money received as a share of “normal” assets — The exiting partner receives monthly payments that represent their share of the business's assets. The departing partner is taxed up to 23.8% on the difference between total payments received and the partner’s tax basis. These payments are not tax-deductible to the business.

Money received as a share of “hot” assets — Most “normal” assets are taxed only up to a rate of 23.8%. “Hot” assets, however, can be taxed up to a rate of 37%. “Hot” assets refer to assets that can generate income in the future, such as accounts receivable and inventory.

The tax implications of buying out a departing partner can be very complex and require careful planning to avoid paying more in taxes than necessary. Partner with 1-800Accountant to help you create a tax game plan that’s a win-win for both the business as well as the departing partner.

Get expert help right away

Remember, as soon as you know that you’ll be involved with a partner buyout, seek immediate professional help. Trying to perform any part of a buyout transaction without the guidance of legal or tax experts can be costly.

Working with your business tax and accounting partner at 1-800Accountant can take the stress and guesswork out of properly structuring a partner buyout and minimizing your taxes. Call today to schedule your free tax advisory session!