Issue 6

Transferring the Business to Children or
Employees: A Recipe for Disaster?
(Step Five)

How do you successfully transfer your business to a child, key employee or co-owner? We feel the most successful method is to follow a recipe, which mixes, in equal measure, three key ingredients:

  • One part: the ability, experience, and dedication of the prospective new owners;
  • One part: a company with strong, consistent cash flow and little debt; and
  • One part: a transaction designed to prevent income taxes from eroding the cash flow available to you, the seller.

It should be obvious that a business cannot be successfully transferred unless the new ownership is capable, nor can we expect the transfer to be successful if the business itself lacks the ability to provide an ongoing stream of income with which to pay for the business acquisition. What may not be so obvious, however, is the corrosive affect of income taxation upon the sale of a business to "insiders" -- children, key employees, or co-owners. Let's look at two key facts.

First, your children or key employees may not have cash to buy you out. Therefore, any sale will take many years to complete¡Xa potentially risky prospect. Further, all of the cash used to purchase your ownership must come from one source: the future cash flow of the business after you have left it.

Second, without planning, the cash flow can be taxed twice. It is this double tax, (usually totaling more than 50 percent) that spells disaster for most internal transfers. Through effective tax planning, however, much of this tax burden can be legally avoided. Witness what Karl Clark did.

Karl Clark agreed to sell his company to a key employee, Sharon Smith, for $1 million. This value was based on the company's annual $250,000 cash flow, which Karl historically took in the form of salary. While Karl understood that Sharon could not pay $1 million (nor could she secure financing) he did think that she could buy out the company over a five or six year period, using the available cash flow of the company.

Karl's calculations were way off the mark. The time needed for a buy out was at least 10 years. But why were his calculations so off base? In a word, taxes -- actually in two words, double taxation. Without proper planning, this is what happens if Sharon buys the company (and what can happen to you when you attempt to sell your business to your children or employees):

  1. Sharon receives the cash flow ($250,000 per year) and is taxed on it at a 40 percent rate.
  2. Sharon pays $100,000 in taxes (40% of $250,000). This is the first tax on the business' cash flow.
  3. Sharon pays the remaining $150,000 (net after tax) to Karl.
  4. Karl pays a 20 percent capital gains tax on the $150,000 he has received for the sale of his ownership interest, or $30,000 in taxes. This is the second tax on the original stream of income from the business. The result?
  5. The company distributed $250,000 of its cash flow but Karl was only able to put $120,000 in his pocket.

Without proper tax planning, you too will pay an effective tax rate in excess of 50 percent on the company's available cash flow used to fund your buyout. This is likely to prevent, as it did for Karl and Sharon, a consummation of the sale of the business.

How might you avoid disaster and design your sale to minimize taxes and to maximize the opportunity for success?

  1. Plan. Like Karl, you must have a plan that yields you a greater after-tax amount for the sale of your company. Since the cash flow of the company will not change, the key is to provide Uncle Sam a smaller slice of the available cash flow.
  2. Use an experienced advisory team, usually consisting of a business attorney, CPA and insurance or financial professional. They must understand the importance of tax sensitivity to both seller and buyer in order to make more money available to you.
  3. In addition, you and your advisors must use a modest but defensible valuation for the company. Because a lower value is used for the purchase price, the size of the tax bite is correspondingly reduced. The difference between what you will receive from the sale of your business, at a lower price, and what you want to be paid to you after you leave the business is "made good" through a number of different techniques to extract cash from the company after you leave it.

Tax planning for the sale of your company to an insider takes time, it takes planning, it takes expertise, but it can save a tremendous amount of money. Take time now to begin the planning process:

  • Learn as much as you can about how to best accomplish the transfer of your business.
  • Seek the advice of your advisory team sooner rather than later.
  • Act sooner rather than later. Taking action now will ensure that your business transfer recipe provides a delicious result. Bon appetit!

Subsequent issues of The Exit Planning Navigator® discuss all aspects of Exit Planning.