Exiting Your Business can be a Taxing Experience
Beware of these ﬁve critical decisions that could sabotage your business exit and retirement.
Roofing contractors work tirelessly to build and grow their businesses. After long hours and substantial risk-taking, the business owner has created an asset that, if transferred efficiently, could provide financial security for themselves and their families. We’ve found that most owners have about 70 percent of their wealth trapped inside their illiquid business, and research supports this.
According to PricewaterhouseCoopers — a multinational professional services network headquartered in London and the second largest professional services firm in the world — 75 percent of a typical business owner’s net worth is tied up in their company. Perhaps, more surprisingly, only 22 percent of those owners have reported doing any succession planning.
With so much of their wealth trapped in the closely-held business, there’s a real fear that once they exit their business, they will outlive their money. This emotional fear can be the largest obstacle for business owners to overcome when transferring their business.
However, with proper education and planning, business owners can position themselves to make a confident decision. Start early, as time is your best friend in this complicated process.
When the owner finally faces the decision of how and when to leave, one of the key components is how to reduce the level of taxes triggered by the exit. With the changing economic climate, taxes are and continue to be one of the major pieces of the puzzle that needs deciphering in order to maximize net proceeds to the business owner.
Combined federal and state tax rates can be as high as 55 percent or greater. Therefore, early tax planning is critical in helping achieve the owner’s financial goals.
When exiting a business, there are five major decisions that the business owner will make over the life of his career that can have a profound effect on the amount of taxes he or she will eventually pay when the transaction is executed.
1. Entity Formation
A key indicator in determining the tax ramifications for the buyer and seller is the entity formation. Most companies are structured as either C corporations, S corporations, LLCs, partnerships or sole proprietorships. With the advent of the LLC, the C corporation is becoming somewhat extinct in the closely held business arena. However, a considerable number of C corporations are still in existence today and expose the corporation to double taxation.
These entities require a significant amount of planning in order to achieve the business owner’s financial goals upon liquidation. Selecting or changing to the appropriate entity formation can mean the difference between realizing an effective tax yield in excess of 60 percent or as little as zero.
2. Deal Structure
Generally, transferring a business is accomplished through either an asset sale or equity/stock sale. Selling a stock carries a capital gains tax. Selling assets is taxed as income. Each method proposes advantages and disadvantages to both the buyer and seller and is often subject to much negotiation.
Of paramount importance to the buyer is: minimizing unknown liabilities; maximizing step-up basis in assets; speeding the write off of assets purchased through various depreciation methods; minimizing the purchase price; stretching out the payment terms; and obtaining adequate representations and warranties.
Conversely, the seller is trying to maximize the sales price while reducing the tax burden and accelerate payments from the buyer in order to minimize the financial risk of non-payment. Achieving these goals by both parties can often be a long and arduous process.
3. Tax Code
The Internal Revenue Code can be your best friend or your worst enemy. With the proper strategy, the code can be used to your advantage by utilizing various techniques to reduce, defer or eliminate taxes altogether and put more dollars in your pocket.
Remember, it’s not so much what you get in the transaction that’s of key importance, it’s what you keep.
4. Asset Protection
How would you feel if you were sued for an action in which you had no involvement? All too often, asset protection is equated with insurance or other financial products. However, there are times when risks are not insurable or a claim is so high that it exceeds your coverage.
Utilizing various entity types with protective characteristics can provide business owners with the level of protection needed from creditors and predatory lawsuits. Would you agree that if you lost everything you had there’d be no need for financial, tax or exit planning?
5. Proper Coordination
All too often we see that business owners have taken the initiative to start planning for various aspects of their lives. Life insurance is acquired, wills and trusts are developed, and perhaps a buy/sell agreement has been created. Just as often as we see these plans in place, we discover that the lack of coordination between them can and will lead to unintended consequences.
Each aspect of a business owner’s personal, business and financial planning goals should be examined, coordinated and integrated in order to support the owner’s motives and goals. Non-taxable benefits are structured in a manner that will make them taxable. Assets will revert to the unintended recipient.
These are but a few of the consequences often realized when documents aren’t coordinated with an owners’ goals. The “fire drill” concept should be utilized in order to determine what the actual effect would be to the business and family should one of the documents need to be triggered.
Editor’s Note: U.S. Treasury Circular 230 requires that any tax advice provided in the following column is not intended or written to be used, and cannot be used by you, for the purpose of avoiding penalties that the IRS could impose.