As many business owners painfully discover, successfully building their enterprise does not always directly translate into successfully building their personal wealth. Especially given day-to-day business demands, it is easy to lose sight of the ultimate business’s purpose, which is enhancing the owner’s personal wealth. Converting a business into a wealth enhancement vehicle requires ongoing concerted, systematic effort. At some point the owner must also worry about the business if something should happen to him/her.
These are the five critical challenges I have most often encountered after having worked extensively with business owners over the past 25 years. These can represent opportunities if properly addressed on a timely basis; in not, they may become detriments.
1) What strategies can help keep my taxes as low as the law allows? With the goal of helping the owner and business keep more of what is earned, there are a wide range of tax planning opportunities that come with business ownership:
a) BUSINESS ENTITY: Effective tax management starts with the firm’s chosen business structure. In certain instances, for example, a Sub Chapter S Corporation could allow operating losses to pass to the owners, thereby providing personal tax benefits. In other situations, a regular “C” corporation may protect owners from pass through income that could otherwise have an adverse effect on their personal taxes. An LLC may offer advantages of each. It is important to periodically review the structure in light of current and anticipated business performance over the foreseeable future.
b) TAX ADVANTAGED BENEFITS: In addition, there are a wide range of options that may provide benefits to the owner as well as selected employees on a tax advantaged basis. These can include health & welfare trusts, individual pension plans, retirement compensation arrangements, holding companies, charitable donations and estate freezes. How beneficial these may be requires careful consideration of the individual situation.
c) TAX DEDUCTIBLE PAYMENTS TO OWNERS: Often it can be advantageous for an owner to purchase an asset personally, then rent or lease it to the business. This can involve equipment or real estate, and can not only allow the entity to deduct the payment from its tax return, but also allow the recipient owner to shelter a portion of taxation from that payment with depreciation, interest and other expenses, thereby enhancing the owner’s benefit.
Effective tax management requires continual effort; strategies need to adjust as the owner’s goals and financial situation changes.
2. How can I protect my business and personal assets against liability? Especially in this litigious age, protecting business and personal assets against a liability claim is critical to financial success. Again, a starting point lies in the limited liability protection found in the appropriate business entity. While this may not protect the business itself, it may protect the owner’s personal assets. Beyond that, it is important to:
a) Periodically review the basic corporate documents (articles of incorporation, bylaws, meeting minutes, etc.) to assure they are in good order and properly maintained.
b) Make sure employees are not given the appearance of greater authority than the owner intends they have. Their job titles should be consistent with their function, with appropriate checks and balances that a “prudent business person” would take to assure employees are acting within the scope of their authority.
c) Review capitalization levels to make sure that excess cash or unrelated assets are not being left in the firm unnecessarily.
d) Consider general and professional liability insurance that could protect against allegations of negligent activities or failure to use reasonable care.
3. How can I protect my business against the death, disability or departure of one or more key people, and do that before events take my choices away? Because small businesses are so dependent on one or a few key employees, their inability to perform can result in tremendous lost revenue. A multitude of planning tools is available, such as
a) Key Person Life and Disability Insurance, to provide the business with cash compensation to help replace such a costly loss.
b) Buy-Sell Agreements can provide contracts to compensate families and provide for smooth ownership transition in the event of death.
c) Split Dollar Life Insurance: Adds tax advantaged savings features to the aforementioned benefits the business might receive should one of its key personnel die unexpectedly.
Owners typically want to make sure their family is duly compensated for the business they’ve built and that the right people are at the helm in their absence. All told, it is important to have a comprehensive protection plan that can provide continuity and protect the business value should the owner or a key person be lost or become disabled.
4. How can I convert my business into planned retirement income? Key to this is the business’ ability to successfully operate separate and apart from its owner, and the potential that it can be objectively and accurately valued. With all businesses, especially those that are primarily service oriented, it is important to transition from one that is “Lifestyle Based” to one that can be “Equity Based.” Lifestyle, as the name implies, is purposed to support the owner’s living standard according to his/her schedule, income and tax benefit needs. As such, the value is based on the owner and typically diminishes or vanishes when he/she retires or passes.
By contrast, an Equity Based organization is designed and run with the intention of providing a value that can be accessed by the owner or his/her family at some future time. Keys to developing an Equity Based entity include:
a) Team Staff: The owner must be surrounded by people capable of replicating the product or service, thereby extricating him/her from the day-to-day business operations. Critical in this is the staff’s capability to handle routine matters especially those that involve customer contact. The owner involvement of course remains, but is elevated to a significantly higher level like new business development and strategic planning.
b) Structured Procedures: Key to the businesses equity value is its ability to deliver a consistently high quality product or service independent of the owner’s involvement. A “replicable” process can only be based on developing clear procedures and guidelines that motivated staff can follow without the owner’s constant oversight and direction. Michael Gerber’s “E-Myth Revisited” provides an excellent foundation for proceduralizing that replicable process.
c) Developing & Retaining Key Employees: Depending on size, having one to three key employees who can act as the owner would, take pride in the business’ success, and have effective incentives to thrive personally along with that success, is essential. Elements can include bonus based on performance and results, and even potential incremental ownership over time.
Succession can involve ownership transference to family members, co-owners, current employees or an outside third party. The key is that the entity be capable of operating separate from its owner, and that the transference done in the most tax advantaged manner possible. Depending on the circumstances, this can result in a lump sum, a payment over time, an on-going interest in the entity or some combination of these.
5. Which Qualified Retirement Plan is best for my situation? 401K, Profit Sharing, Defined Benefit Pension, SIMPLE or Simplified Employer Pension. Several factors need to be considered, including:
a. Variability of business revenues and income: Generally, greater tax benefits are available at the cost of higher committed plan contribution levels. The downside, of course, is that in lean years it could be difficult to maintain those higher contributions. It is important to carefully weigh these, and often advisable to err on the side of greater flexibility and lower contribution levels. This is especially so given recent enhancements to the traditional 401K plan.
b. Owner or Employee Emphasis: ERISA is the major body of regulations that specifies minimum participation requirements for rank and file employees. Typically all must participate equally for any contributions made for owners and key employees up to specific levels. Within these rules is some flexibility that can allow owners to receive a relatively greater proportion of dollars contributed. This is especially so if the firm is willing to make prescribed minimum contributions under “Safe Harbor” provisions, and/or if the key employees have a significantly higher average age under “Age Weighted” arrangements.
c. Retention: Ensuring that the dedicated staff built through the years is sufficiently compensated so to not be tempted to look elsewhere for employment is important. It may also be a priority to provide them with an incentive to begin saving for their futures. This is especially so since many workers are not saving enough to be able to live comfortably after retirement and the owner worries about their well-being.
Every business weighs the relative importance of these issues differently. Generally, each plan has trade offs between amount of annual tax-deductible contribution allowed, flexibility of varying that contribution in good and lean years, and a desire to reward employees versus encourage them to save for themselves. When properly done, the right retirement plan can provide the owner with effective tax benefits now, a stream of reliable income well into retirement, and a motivational-retention tool for important employees.
A Motivational Fact: Every owner will one day leave the business. The question is, will it be on his/her own terms or dictated based on health or financial circumstances? When it is properly planned, it can be a positive, life changing, wealth creation event that brings financial independence to the owner and/or family, and has the added benefit of leaving the business a healthy, viable entity that can flourish long after the owner departs.
A qualified financial advisor can help develop a clear picture of the business's value and then integrate that information with the owner’s personal financial situation to give a comprehensive view needed to plan for a successful future.