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June 30, 2002 at 08:00 PM
Solve The Double Tax Buy-Sell Problem
By
All business owners share one problem in common. They eventually want a liquidity event.
Someday they will need to turn their business over to a buyer. There essentially are three prospective buyers–a family member, an inside buyer, or an outside buyer.
To be successful in the business market, you need to think like a business owner and help them understand the end game. There is one basic rule to business transition. If you understand this rule, you can do a lot of business.
“There is no such thing as new money.”
What does that mean? Its simple–every business owner eventually will be bought out of their business with their own money. At first blush, this is a difficult concept to grasp, but once the concept sinks in, it becomes the key to your sale. When an outside buyer purchases the businesswhat do they use to pay for the purchase? They use the income stream the business would have created had the buyer never sold.
Whose money is that? Its the sellers money. This is the primary reason to use permanent life insurance in a business case. You use it to fund the owners exit strategy. If its his own money why not start planning now.
In order to explain this concept, you need to understand the taxation of a business transition. I call it “The $1.82 story.” This may be a surprise to you, but the transition of a business is the most heavily taxed transaction in the tax code. The tax approaches 110% of the sale price of the business.
Heres why. If you sell your business for $1, how much will you net from the sale? If we assume it is a capital gains transaction, the tax rate will be between 20%-28% depending on the tax jurisdiction.
Lets assume the tax is 28% for our purposes, since I practice in California. This means our business owner will net $0.72. But what taxes did the buyer have to pay?
Whether I am working with a buyer or a seller I always ask my prospect this question, “Are there any other taxes that have to be paid?” Most prospects will say, “Nohow could there be? Buyers dont pay tax.” And while this is absolutely true, in theory, it is not true in operation.
Here is why. When the buyer writes a check, where does the money come from to pay the seller? It either comes from accumulated capital or from financing. In either case, the buyer purchases the business on an earnings multiplier. They are expecting to recover their investment in 5-7 years.
If they are going to retain the business, they recover their capital as taxable business income. In a 45% corporate tax bracket how much income do they have to earn to receive $1.00 to recover their $1.00 of capital? Most clients will say $1.45.
But is it?
Lets look and see. If you earn $1.45, and pay a 45% tax, the tax is $0.65 and you net $.080. But $0.80 is not their original $1.00. So how much do you have to earn to net $1.00? You have to earn $1.82. You pay $0.82 of tax and net $1.00 of income.
