As business owners, we probably pay more in taxes than we’d like. Plus the rules about exemptions, regulations, fees, and taxes seem to change constantly. But with the changing tax environment comes opportunities to reduce your tax burden if you know where to look. Early planning, however, is required to make the most of this strategy.
The final installment of the Business Killers educational series shows that even successful business owners still need to navigate potentially rough seas to reach their final destination without losing too much of the value that they may have spent years to build.
The scene opens on a business owner in his early 60s meeting with an advisor. The business has successfully acquired another company and profits continue to accumulate as part of healthy business growth.
All of the growth means increased income for the owner, and with it, a significantly higher tax bill. He’s frustrated about what he perceives as a disincentive to success. And with retirement not too far away, the advisor warns him that a sale of the business will result in a much larger tax bill than the one he’s bothered about now. “Stop trying to cheer me up,” the owner half-jokes in frustration.
Having to pay taxes on money that you’ve earned may sound like a “first world problem.” And it’s certainly true that paying taxes because your business is successful is almost always better than not paying taxes because your business is losing money. But there is no reason to pay more taxes than necessary.
Tax Planning is Part of Your Exit Strategy
Tax planning is an important but sometimes overlooked part of an exit strategy. The more time you have to plan, the more likely you are to achieve the results you want. The amount of tax owed from the sale of a business depends upon whether the sale proceeds are taxed as ordinary income or capital gains. Profits from the sale of business assets likely will be taxed at capital gains rates, but money paid to an owner for transition consulting services probably will be taxed as ordinary income. And as discussed in an earlier post, the structure of the transaction (stock sale v. asset sale, allocation of purchase price, etc.) will also have consequences.
In this case, the owner isn’t stepping down tomorrow, but he won’t be working another 10 years either. For him, and for any of you who plan to sell your business, it’s not too early to begin working with your team to estimate the likely tax bite from a sale of the company and come up with a plan to fund that liability.
Ben Franklin famously said that the only certain things in life are death and taxes. As we continue exploring the perils depicted in the Business Killers educational program, we’ll see what happens when a business owner doesn’t spend enough time planning for the second part of Franklin’s maxim before the first one occurs.
A widow meets with a lawyer and her two adult children shortly after her husband’s funeral. The news is grim. The children get half of the family business, but due to a lack of estate planning, they now owe $5 million in estate taxes based on the value of the company. Due to the loss of the company founder, the value of the business has dropped, so it may be much more difficult for the family to get a loan to pay the taxes. Although there is some life insurance, it isn’t enough to cover the tax liability. Regardless, the benefits are payable only to the widow, who now owns the other half of the company. Worse, there is no written succession plan for the business, and the two children are already jostling for control of the business.
In this case, taxes are a big part of the problem. Although a spouse gets their portion of an inheritance tax-free, children, friends, or business partners do not. The so-called “death tax” comes in two forms: federal and state. The federal estate tax applies to estates valued at more than $5,250,000. But many states are not so generous. Oregon’s estate tax applies to estates valued at more than $1,000,000. And while many people might think that sounds like a lot of money, consider that your estate includes not just the value of your business, but your home, retirement accounts, investments, and life insurance proceeds, as well as your other personal property.
In this case, the larger issue actually involves the lack of succession planning. By not designating someone to take control of the business, the deceased owner has created a leadership vacuum and a looming power struggle as family members and remaining employees argue about the fate of the embattled company.
Running a successful business is time-consuming, and as Lisa Brumm, a member of the Business Killers team of professionals often says, estate and business succession planning when you’re young and healthy has all the appeal of cleaning out the garage on the first sunny weekend of the year. But failure to plan is planning to fail, and it is incumbent on the founder of a company to take necessary steps not only to preserve the value of the company but to spell out intentions for ownership, control, and leadership for the next generation in a written succession plan.