It's not how much you make but how much you keep

Experienced advisers can help you save money during your business exit

I learned a great deal from my personal business exit and wish I knew then what I know now. In retrospect, my company's management team made its share of innocent mistakes exiting the company. In the late '90s, we spent several years and more than a quarter of a million dollars wandering the exit path with merger and acquisition consolidators, private equity groups and an employee stock ownership plan (ESOP) adviser; finally, we decided to use a management buyout.

With the advice of an experienced exit planner, we could have reduced our costs 70 percent; defined our goals and produced a holistic report laying out our options, bottom line after-tax pricing and income replacement; and structured an exit to address tax and estate issues.

So what does this mean for you? Don't make the mistake of thinking you know everything about business transfers because you have been involved with one in the past. My company's most recent transition was our third buyout into our fourth generation. My message to you is simply: You don't know what you don't know.

The basics

There are some basic concepts you should know when beginning to establish your exit plan.

Remember, time is your best friend. It provides a period for critical succession and alignment and allows you to structure internally for income replacement. Beginning to plan 15 to 20 years in advance is ideal; five to 10 years in advance still can work.

You may be thinking: Is it realistic to plan this far in advance? To clarify, planning during the five to 20 years in advance should concentrate on tax effect methods to save your company money, aligning your management succession team and having a flexible plan. Then, depending on the type of exit you ultimately choose, your exit's implementation should begin during the years closer to your retirement—once you have satisfied your goals and the succession team and new owner are prepared to run the company without you.

It also is important to remember that, essentially, you buy yourself out with your own money. In other words, the company pays for everything.

But be careful to avoid double tax: The first layer of taxation consists of payroll and income taxes that can equate to an effective tax rate equal to 50 percent. The second layer of taxation occurs when the stock is sold. This transaction will incur a gain that will be taxed at 15 percent. This rate recently was extended for two more years.

To help avoid the double tax, develop the lowest defensible valuation for the business. Receive money from the company-then it will be taxed once to you and fully deductible to the business. Retirement planning and deferred compensation becomes fully deductible by the company and tax-deferred to the owner.

With the help of professional exit planning advisers, you should explore all legal methods to reduce the cost to the company through trusts, tax planning, insurance and estate planning.

An inefficient plan

In an internal exit—an ESOP or management buyout—the profits pay for the purchasing of the owner's stock. So a lot of financial risk in such transactions is diminished, and the money saved can be better used by reinvesting in the company. A management buyout is the most common construction business exit.

Most of the time, a business owner's largest asset is trapped in his or her illiquid business. Monetizing that wealth likely will be the largest financial event of the business owner's life. Such a transaction will include three parties: the seller, the buyer and the government.

You must understand: It is not how much you make but how much you keep.

For example, assume a $1 million structured buyout of an S corporation occurring during a 10-year period. The buyer would need to earn $1.666 million to net $1 million (35 percent federal + 5 percent state = 40 percent tax). This does not include other benefits and burdens. The buyer pays the owner $1 million to net $800,000 (15 percent capital gains + 5 percent state = 20 percent tax).

Translation: The buyer would need to pay $866 in taxes to net $800,000 for a $1 million stock price. A $10 million payout would cost $16.666 million and net $8 million.

Now, suppose in 2011 the owner has an estate tax exposure and other jointly held assets with his spouse totaling more than $10 million. The government could come in for another 35 percent tax to reduce the $800,000 by $280,000, leaving the owner with $520,000. In the end, the contractor would pay $1.146 million in taxes for his family to collect only $520,000.

Obviously, it is inefficient to spend $1.6 million to get $800,000 or $520,000 when you can legally structure a deal to net nearly $1 million less 1 percent ($10,000) in taxes (plus legal advisory fees). Unfortunately, I see such scenarios too often.

A better option

So what should an effective exit plan look like from the beginning? The following example explores one possible solution based on an owner's goals. (Keep in mind, this is a simplified explanation.)

Assume a company owner wants to get his company stock into his son's hands in the most tax-efficient manner, remain in control of the company, continue his income and benefits, and save pre-tax income (deductible to the business) in a tax-deferred manner.

First, the owner's common stock should be recapitalized by exchanging it for voting and nonvoting stock. The owner would keep 1 percent of the voting stock and use the 99 percent of nonvoting stock for the transfer. Recapitalization is essentially tax-free and works with C and S corporations. The owner would remain in complete control of the company and could stay on as chairman of the board until he sells the 1 percent voting stock.

Next, a unique kind of trust would be set up in which the owner can transfer the nonvoting shares to the buyer in a structured sale during a period of years. The owner could maintain control of the company by keeping the 1 percent voting stock and transfer the nonvoting shares through the transaction. Assuming the trust is properly written and structured, the owner could transfer the company to his children or management in an essentially tax-free transaction.

This type of trust works best when a business is worth $2 million or more and works efficiently with your estate planning. The plan works best when instigated 15 to 20 years before an owner's retirement date.

Good versus great

In his book Good to Great, Jim Collins, a business consultant and lecturer on company growth and sustainability, discusses the difference between good and great companies, schools, teachers, doctors and lawyers.

There is a measurable difference that can be personalized if you ever have considered surgery, for example. You certainly want a great surgeon who routinely performs the surgery you require. I would be more than willing to travel for a great surgeon to reduce my risk

The same analogy works with your business exit. Most exit planners will use an exiting owner's existing attorneys, financial planners, etc., or, at the owner's request, bring in experts who specialize in private business exits in mid-capital markets. The exit planner coaches and creates the roadmap for the professional advisers to improve and implement in the most effective, efficient manner. Naturally, you want a great adviser who knows what he or she is doing.

Our company had good—though not great—advisers with good intentions and with whom we had long relationships. However, great advisers could have created a great deal of savings for our owners and the company.

Kevin Kennedy is founder and president of Beacon Exit Planning LLC, Elmira, N.Y.



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