Who’s going to own your business (or practice) after you? Every transaction has three parties:
- BUYER, SELLER, and GOVERNMENT; or
- PARENT, CHILD, and GOVERNMENT
Who benefits most from the traditional approach used by a child of the owner, key employee, or outside buyer? Let’s look at a recent example:
- SELLER promised three employees that they would succeed him in ownership and management
- The BUYERS did not have the funds available to buy the business
- So, the SELLER increased their compensation. Don’t laugh. That’s what I run into all the time with children of business owners as well as with key employee buyers.
- What the result is:
(1) BUYER needs to earn $166,667/year for 10 years in order to net $100,000/year for 10 year to pay $1,000,000 for the business (assuming a combined 40 percent federal and state income tax).
(2) SELLER nets $80,000/year after capital gains (assuming a combined 20 percent federal and state capital gains rate and zero cost basis)
(3) GOVERNMENT collects $666,667 in taxes from the BUYER and $200,000 in taxes from the SELLER = 52 percent of the original $1,666,667
Even if the BUYERS were able to take out a $1,000,000 loan, they would have to earn the same $1,666,667 pre-tax in order to pay back the $1,000,000 principal. The SELLER would still lose $200,000 to capital gains.
Every dollar allocated to an OWNER is not deductible and the value of the ownership interest is included in the owner’s taxable estate. The same dollar allocated by the same business on behalf of the same person, but this time as key EMPLOYEE, is either tax-deductible or can be received by the employee’s family free of estate taxes.
Using Employee benefits instead of Employer benefits
If we have enough time (typically 7 years or longer) before the exit event (retirement), then we can take advantage of an old friend, the defined benefit pension plan. Here’s how this one worked:
In this case, the owner wanted the three key employees to pay him $3M over 10 years. His value was based on a formula of 5 times EBITDA of $600,000. Using our example, above, the key employees would have needed $5,000,000 pre-tax to net $3,000,000 after tax (net of 40 percent) with the owner netting $2,400,000 (net after 20 percent). After we installed the pension plan, the EBITDA dropped by $229,525 to $370,475, making the OWNER value $1,852,375 for 100 percent. We further, intentionally, decreased the value of a one-third interest to $411,639 (applying a one-third discount for lack of marketability and lack of voting control — discounts can range from 15 percent to 40 percent, and sometimes even higher — professional valuations of discounted interests should be used).
One of the three key employees was the owner’s son-in-law. He met the owner’s daughter while working at the business. So, we had the owner transfer one-third of the stock to a trust for the benefit of his daughter, with the key employee son-in-law as trustee, provided he remain married to his daughter and remained a full-time employee in the family business in a management capacity.
We sold the other two-thirds using $1,372,130 pre-tax dollars (vs. $5,000,000) to net $411,639 for each of the remaining two BUYERS. The selling OWNER netted $1,097,704.
After 10-years, the retiring key EMPLOYEE will have over $2,000,000 in his retirement account.
Oh you say, but that $2,000,000 is still subject to income taxes. Right, but with other assets in place, the selling OWNER/retiring key EMPLOYEE only needs to take required minimum distributions (RMD) during his lifetime. At his death, there is sufficient life insurance, owned outside of his taxable estate, to reimburse his family for the income taxes paid on a Roth conversion at his death.
We placed life insurance on the lives of all three key employees, not only to fund their buyout of the current owner, but also to fund their own buy/sell cross-purchase agreement. (See my article about estate-enhance cross-purchase planning.)
If we don’t have enough time (typically less than 7-years, and sometimes less than 7 months), we use non-qualified plans.
What is the value of your business (or practice)?
What would a willing buyer pay a willing seller when neither is compelled to buy or sell? With all deference to valuation professionals, assets have a range of values. In a divorce, one spouse wants a higher value for certain assets than the other spouse wants.
In business succession, the BUYER wants to pay the lowest price possible. BUYERS want to look at the financial statements as if they were covered with black crepe (weak industry, lots of competition, weak economy, etc.). They want to buy the last five years. SELLERS want to look at their numbers as if they were wearing rose colored glasses. They want to sell that next five years of expected profits.
We use the BUYER price for estate planning “equalization” (better stated, “fairness” conversations) when some family members will succeed their parent in ownership and management and others will not. We use the BUYER price when we have either inside or outside buyers. We use employee benefits to fund the difference between the buyer price and the seller price, since those dollars can be far more tax efficient.