Do your business owner clients have an exit strategy? Do they intend to sell the business to a relative, key employee(s) or an unrelated third party?
It’s well documented that an effective succession strategy is a challenge. Your clients’ objective may be to secure a market value sales price, continuation of the business’ success for the buyers and employees, perpetuity of the business’ culture and values, or some combination thereof.
Typically, the primary challenge that owners face is receiving fair market value for their closely held business. A prospective third-party buyer realizes the talents and relationships that represent the goodwill value are tied to the owner. Without an employment contract to retain the owner, the value is reduced and the seller may want to avoid an employment contract.
An alternative is to sell the business to a key employee or employees. This approach provides a readily identified buyer whose expertise and familiarity with the business enhance the business’ chance for ongoing success. The outgoing owner may have interest in that ongoing success financially and psychologically. The problem with a sale to key employees is that they rarely have capital for a down payment, much less purchase of a business.
Another challenge is tax risk. The seller will be subject to capital gains tax, and perhaps ordinary income tax, on sales proceeds. The buyer is purchasing the business with after-tax dollars and, therefore, is paying an increased cost.
Default risk presents yet another challenge. If the buyer is making installment payments, those sales proceeds may ultimately depend on the ongoing success of the business.
The shared tax & equity partnership (STEP) may be an attractive exit strategy for addressing the aforementioned challenges. STEP would provide the following advantages:
? a mechanism to share opportunity, equity, and responsibility with top key employees without sharing ownership in the core company;
? a current year income tax deduction to the company;
? tax-favorable sale proceeds to the selling owner when he/she is ready to exit;
? golden handcuffs for key employees to encourage them to remain with the business;
? flexibility to customize the exit strategy, as the owner can decide who participates; and
? a device that facilitates a carefully planned transition of the company.
How the STEP works
An LLC or LLP is set up with the business owner as the managing partner and given a minimum interest in the partnership, like 1%. The other 99% interest is owned by the top key employees (no voting rights), as limited partners.
The owner transfers a piece of property (e.g., equipment, machinery or real estate) into the STEP LLP. The core company makes the tax-deductible lease payments to the STEP LLP for use of the property. Because of the ownership split in the LLP, the key employees bear the tax burden on most of the lease payments. This “skin in the game” (or increased tax liability now in exchange for future equity opportunity in the core company) provides an effective litmus test to see which key employees are serious prospective owners.
The STEP deposits the lease revenue into a sinking fund that will eventually become seed capital for buying the owner out of the core company. Default risk is reduced and the lack of capital is addressed. Cash value life insurance provides an effective funding vehicle for the sinking fund.
The cash values grow tax-deferred and, at the time of sale, the policy can be transferred to the seller income-tax-free. If insurance is used, the insured(s) should be the younger employees so the insurance cost is minimized, and the case value maximized.
The STEP offers flexibility in the event of key person turnover. A properly drafted STEP document will provide buyout provisions in the event of a key employee termination. It will also have a provision for additional key employees to join the STEP, at the owner’s discretion.
In summary, the STEP can provide an efficient business transition and exit strategy for the small business owner. It addresses key employee retention, tax risk and capital risk. And it helps assure ongoing success of the company.