Business owners work effortlessly to build their closely held businesses. After long hours and substantial risk-taking, business owners have created an asset that, if transferred efficiently, could provide financial security for themselves and their families. We have found that most owners have around 70 percent of their wealth trapped inside their illiquid businesses.
Seventy-five percent of typical business owners’ net worth is tied up in their companies. 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 is a real fear that once they exit their businesses, they will outlive their money. This emotional fear can be the largest obstacle for business owners to overcome when transferring their businesses. However, with proper education and planning, business owners can position themselves to make confident decisions.
When owners face the decision of how and when to leave their closely held businesses, one of the key components is configuring how to reduce the level of taxes triggered by the exit. With the changing economic climate, taxes are, and continue to be, major pieces of the puzzle that need to be deciphered 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 owners achieve their financial goals.
FIVE MAJOR DECISIONS
When exiting a business, there are five major decisions business owners will make over their careers that can have a profound effect on the amount of taxes they will eventually pay when the transaction is executed. The following is a brief discussion on these topics.
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-corp is becoming somewhat extinct in the closely held business arena. However, a considerable number of C-corps are still in existence today and expose the corporation to double taxation. These entities require a significant amount of planning in order to achieve business owners’ 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 accelerating 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 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 is 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 amounts. Utilizing various entity types with protective characteristics can provide business owners with the level of protection that is needed from creditors and predatory lawsuits. Would you agree that if you lost everything you had, there would be no need for financial, tax, or exit planning?
5. Coordination of Business, Personal, and Financial Planning — All too often we see business owners have taken the initiative to start planning for various aspects of their lives. Life insurance has been acquired, wills and trusts have been developed, and perhaps a buy-sell agreement has been created; however, just as often as we see these plans in place, we discover 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 and integrated in order to support the owner’s motives and goals. Nontaxable 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 that are often realized when documents are not coordinated with 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.
U.S. Treasury Circular 230 requires that this firm advise you that any tax advice provided was not intended or written to be used, and cannot be used by you, for the purpose of avoiding penalties the IRS could impose upon you.
Publication date: 9/19/2016
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