In football, great quarterbacks excel when they’ve reached the "Red Zone"—the last 20 yards before the end zone. Business owners have a Red Zone as well—the final years before exiting. Unfortunately, most business owners aren’t experienced in the Red Zone. With no preparation or game plan, they often fumble away tax savings and their ultimate walkaway money. That’s where you come in.
Ultimately every business owner must answer three key questions:
- How do I create and retain value in the business?
- How do I attract and retain the "super-keepers" who will help me build this value?
- How do I create an exit strategy so I can extract myself from this business and convert its fair market value (FMV) into retirement capital and income?
Let’s take those questions one at a time so you can help your client make the best possible decision for themselves, their family and their employees.
Creating and Retaining Value
The single biggest problem for most business owners is extracting and retaining money distributed from their company. There’s a big difference between profit and personal income. During good times, owners often take out significant bonuses and dividend distributions. But when the economy tightens, they usually have to put money back into the company out of necessity. I call this a lack of liquidity or margin. When the economy tightens, and/or when interest rates rise before the liquidity is restored, owners have few places to turn for business capital. As a result, business owners rarely have surplus capital outside of their business. Their financial independence is compromised by the business’s constant need for cash.
There are two common strategies for increasing owner wealth: Having a well-funded retirement plan and using a split-funded investment grade life insurance program. Most owners know how retirement plans work. But few owners (and their advisors) know about capital split dollar – split funded life insurance strategies. These are specialty programs reserved just for owners and other highly compensated executives in lieu of stock. Unlike retirement plans, they don’t have to be offered to all of your client’s employees.
There are two ways to provide life insurance to business owners:
1. Using after-tax company contributions. The corporation takes bonuses out of company profits and contributes them to a life insurance plan for the owner. This is taxable income for the owner. The company can borrow the money and pay interest to its bank to fund this plan. The company then retires the debt over time, or the owner could use cash values in the future to retire the loan. By borrowing, the company doesn’t have any capital in the plan, initially. The owner can do this for themself from personal income. But sometimes, using the company pocketbook is more palatable.
2. Using leveraged split dollar. Split dollar is a loan from the business to the owner (or super-keepers). By using leverage, the bank loan is then loaned to the owner for a set period (say three to five years); the company doesn’t have to put its capital into the plan. This will supercharge accumulation in the plan. Even though this strategy is a bank loan to the corporation, there’s no impact on the company’s financial statements. The company can also deduct the interest on the loan, and the owner of the policy still receives the net growth in the policy tax-free as long as the policy doesn’t lapse. The internal rate of return of the leveraged plan can be significant if the market performs well, and on retirement, the owner (or super-keepers) can take tax-free income for life.
Retaining the Super-Keepers
Most successful business owners feel pressure to give company stock to their most valued employees—but they shouldn’t. When a loyal, dedicated employee receives stock, and hence becomes an owner, they can suddenly become hyper vigilant about how the company’s money is spent. Owners can no longer take long lunches or deduct golf outings with potential consultants or key accounts. The car they drive is questioned as are long vacations. Sound familiar?
Instead of giving away company stock, encourage your client to consider equity participation plans, aka phantom stock plans, incentive stock plans or stock appreciation rights. Each plan allows the owner to allocate a certain number of shares (phantom shares) to a pool. The shares are then allocated each year based on a formula, and the shares are valued based on measurable metrics using earnings before interest, taxes, depreciation and amortization. But value could be based on increases in retained earnings or some multiplier of net profits.
When selling company stock, owners dilute their ownership and eventual retirement capital. But if they use a phantom plan and allocate profits by formula for each participant, they still retain 100% of the stock and don’t give away control. Further, with phantom plans, owners won’t have audit hawks (that is, stockholding employees) looking over their shoulder, and the money isn’t payable except by the terms of the agreement. Plus, it’s deductible when paid.
Creating an Exit Strategy
With enough advance planning, owners should have several viable ways to exit their business. There are pros and cons, however, to each approach.
1. Liquidate. They could hold on to the business as long as possible and then just have family liquidate the business by selling off all the assets at their death. It’s usually a fire sale with no owner goodwill. Valuable, income producing assets are sold at a substantial discount. Owners typically receive more for their business if sold as a going concern than if sold off piecemeal.
2. Sell to an internal buyer. Company insiders know the business well and will be motivated to sustain and grow it. The challenge is that most inside buyers—key employees—have no money to buy the company outright. So, owners must help them. More on that in a few.
3. Sell to an external buyer. This is considered the holy grail of business succession, but even in good economic times it can be hard to find qualified buyers who will pay all cash all upfront without contingencies. Then there are capital gains taxes (roughly 25% federal, plus state taxes where applicable) and advisory fees, which can range from 4% to 8% of the selling price. After discounts, fees and taxes, owners must ask themselves: “Is the walkaway money enough to support the lifestyle I imagined for myself post-sale?”
Back to the Internal Buyer (Option 2)
For the reasons above, I often recommend selling to someone who works for the company—maybe even a family member. If done properly, the owner can sell 50% of the business for 100% of the FMV today and still be positioned to participate in any upside. That’s right. If the company is worth $2 million now, it can be sold for $2 million today, and the owner still receives 50% of any value increase in the future depending on how the deal is structured. How?
A fundamental law of business sales is that there’s no such thing as new money. Buyers always use the owner’s money to buy them out. When an internal buyer purchases the business, they’re essentially taking the compensation they earn from working for the company and giving it back to the owner. Here’s the trick, however: If the owner is willing to convert capital gains to ordinary income, they can accomplish some amazing results. And they’re all legal under the Tax Code.
Doing so eliminates 40% to 50% of the taxes. The best part is the super-keeper can now afford to buy the business. If structured correctly, it will never cost them anything out of pocket to do it because they’re using company money to do it.
In my next article, I’ll share additional strategies for building and retaining wealth such as captives, long-term care insurance and capital split-dollar benefit plans.
Dr. Guy Baker, CFP, Ph.D., is the founder of Wealth Teams Alliance (Irvine, Calif.). He is a member of the Forbes 250 Top Financial Security Professionals List and author of Maximize the RedZone, a guide for business owners as well as The Great Wealth Erosion, Manage Markets, Not Stocks and Investment Alchemy. He received the 2019 John Newton Russell Memorial Award for lifetime achievement in the insurance industry.
