In the previous blog, I reviewed step three and four of our seven-step process to create a successful business exit / transition plan. In this blog, I will cover step five, which is one that is often overlooked or not dealt with properly.
Transfer to insiders (co-owners, family members or key employees)
Owners who wish to transfer their businesses to family, co-owners or key employees must do the following:
- Minimize the income tax consequences of the transfer to both the seller and the buyer; and
- Minimize the departing owner’s risk of not being paid the entire purchase price by having the owner stay in control until he or she receives every dime of the purchase price.
The reason we emphasize these two conditions is simple: The buyers (children, co-owners or key employees) have no cash.
The only way you as the owner/seller will receive your purchase price is to receive installment and other payments directly from the company over an extended period of time.
All of the money you receive will come from the business’ future cash flow (i.e. income the business earns after you depart).
It is imperative that your exit plan works to minimize the tax consequences to the business and to the buyer in order to preserve a greater part of the company’s cash flow for the departing owner.
Therefore, it is imperative that your exit plan works to minimize the tax consequences to the business and to the buyer in order to preserve a greater part of the company’s cash flow for the departing owner. There are several techniques we can use to accomplish this.
Minimizing ownership value of the business
The lower the price paid for the ownership interest, the fewer dollars are subject to the double tax whammy.
The first whammy is the income tax charged to the buyer (i.e. key employee, co-owner or family member), and the second whammy is the capital gains tax assessed against the seller (i.e. the departing owner).
In other words, for the seller to receive money for his or her ownership interest, the company must first earn the cash that the buyer pays tax on when he or she receives it. The buyer then pays that after-tax amount to the seller as partial payment for the ownership interest, and the seller (owner) pays a capital gains tax upon receiving that money. Hence, there is a double tax on each dollar of cash flow earned by the business that is used to pay for the departing owner’s interest in the company.
Create unfunded obligations
The best way to protect the business’ cash flow (or “golden goose”) from the double tax is to create unfunded obligations to the owner from the business long before the actual transfer. These obligations include:
- Non-qualified deferred compensation for you (the owner);
- Leasing obligations between you and the business, such as a building or equipment;
- Indemnification fees; and
- Licensing and royalty fees.
Reduce risk by maintaining control
The best way to minimize a departing owner’s risk of not receiving the full purchase price is to keep that owner in control until he or she receives every dollar.
To accomplish this, your exit plan might include one or more of the following techniques:
- Securing personal guarantees from the buyer, including business and personal assets
- Holding a controlling interest in your company until financial security is assured
One technique is to use a two-phase process in which the insiders purchase a minority interest in the business.
- Remaining involved in the company until you are satisfied that the cash flow will continue without you.
Transferring a business to children, co-owners or key employees is a high-risk venture. The owner’s ace in the hole is usually the option to sell to an outside party if the insiders/buyers are unable to fulfill their obligations. It is important to remember the business must be structured properly well in advance to gain maximum value and reduce the overall tax impact.
Certainly, the decision to sell the business you created and nurtured is an intensely personal one. No one can tell you when to exit your business or what to do with the rest of your life.
Having worked with other owners, we can help guide you through the process of preparing for the biggest financial event of your life.
We can help you consider all of the factors associated with exiting your business and help you complete your exit objectives.
If you would like an illustration of the seven-step path from where you are to your successful exit, please ask us for our exit plan roadmap. And be sure to keep an eye out for part three of this six-part blog series.
OPES Family Advisory's mission is to continually strive to be the premier wealth management provider to our clients. Through our unique wealth management process, we provide our clients with the intellectual framework to make sound financial decisions. We continually work to provide our clients with unparalleled personal service and peace of mind to allow them to dream, plan and prosper.
Dean Trudeau, CFP, OPES Family Advisory founder began his investment and advisory career in 1987 and has held the designation of certified financial planner for more than 20 years.
His impressive career has grown over the years to include principal of Horizon Financial Services, sales manager of Manulife Financial/Manulife Securities and district vice-president of RBC Global Asset Management.
Trudeau has a deep commitment to his field and over the years has been recognized with many industry awards and has been asked to speak at a variety of conferences. Along with a deep commitment to the profession, he believes strongly in working closely with all his clients in aspects of their lives to give them peace of mind.