Year-End Plans Should Include Exit Planningby
COVID-19 brought personal disruptions, massive government outlays and an unusual mix of business and tax law changes. In such “full-plate” circumstances, business owners and their tax advisors may be hesitant to add more to the planning list. Yet, there is another important topic that should added to the business owner’s year-end planning and that is exit planning. The “particulars” of exit planning can include matters financial and tax related, as well as topics that are more personal.
When considering exit plans, let's first take a look at business structure. Is the current structure of the business still advantageous to the owner? The options may include: sole proprietorship, partnership, C corporation (a corporation that has not elected Subchapter S), the S corporation, or LLC. The LLC route may include filing as a C corporation (See Form 8832).
Is your client’s business structure conducive to having new ownership? For example, one advantage to partnerships relative to the other flow-through option, the S corporation, is that partnerships may have “step-up” inside the entity to reflect ownership changes and revaluations at death (See IRC Sections 734, 743 and 754).
Is one of the flow-through structures, partnership and S corporation options, preferable to the C corporate structure with its 21 percent federal rate? Such questions should be part of your business plan generally, considering both growth prospects and capital needs.
Income earned and taxed at the C corporation may be subject to double taxation as earnings are distributed as dividends. This may be lessened and the timing of shareholder income should be controlled with planning for owner compensation and include shareholder debt in the capital structure. Having owner loans in the capital structure may enable withdrawals from the business without the dividend problems associated with C corporation stock.
Year-end brings together many aspects of the business picture, which can make it a good time to consider such big picture items as type of business structure. What type of business structure is typical of the industry? What type of structure is more likely to appeal to a buyer in the volatile environment of 2020?
Does the Business Run Itself?
If yes, the reader can skip this section. Our topic is employees, their importance to the business and their role as potential buyers. One of the major steps in buyer-identification is considering current employees as potential buyers with enhanced management responsibilities.
Considerations here include whether to approach bankers with key employees, which may entail a loan guarantee by the current owner even if the bank is amenable to lending. Keep in mind that partial business ownership with employees can yield an element of sales proceeds to the current owners, while also bringing key employees to a level of management perspective as owners.
Employee stock ownership plans generally aren’t for the very small businesses. It is sometimes suggested that the business needs at least fifteen or twenty employees for such a structure to be feasible. Such arrangements often involve bank loans to the ESOP, which then buys shares of the owner.
As the name indicates, this approach requires a corporate structure. It tends to be reasonably expensive, but can be the right choice, particularly when there is a significant workforce. There are significant tax incentives designed to encourage the owner to establish such employee benefit plans.
What About Family as Business Owners?
An issue that often arises in estate planning is lifetime gifts of business interests to family versus testamentary transfers. The business and other owner resources have to be fairly substantial to run the risk of incurring gift or estate tax upon the transfer of business ownership interests to family.
However, this is an important 2020 topic because higher exemption levels are in place in 2020. The exemption level as to gift and estate tax is scheduled to revert to its pre-2018 levels after 2025, but there is also some emphasis on 2020 year-end gifts.
The concern is whether political change may translate into significantly lower transfer tax exemption levels even in 2021. The transfer tax exemptions in 2020 are $11,580,000 per spouse (to the extent not absorbed in prior transfers.)
If family is also in management, year-end may be a time to consider transferring some business ownership to the family member. The parental perspective here has to weigh the ownership to be gifted (or sold) to the child, who is also an executive in the business and the degree of ownership of other siblings. If the family business is the bulk of the family’s wealth, it doesn’t necessarily follow that the family member active in the business will be its sole owner.
Gift and estate tax planning is particularly important in year-end 2020 planning because of the relatively high exemptions, which may not last long.
What About Buyers?
Year-end is a good time to begin considering the most likely prospects of a buyer – competitors, business brokers, private equity firms. Year-end reviews are a good time to compare gross margins with competitors toward a goal of enhanced profitability. Such an analysis can also identify successful companies in the industry that are more likely to buy a competitor.
What About the Owner?
Could the owner be less active or more specialized in a niche of the business that is enjoyable and suitable to the owner’s skill set? What sort of sales price and on-going compensation does the owner need to support retirement?
Is the owner particularly talented at start-up or a particular type of industry or phase within an industry? If so, the owner should perhaps focus on where he or she creates the most value. Will the owner be able to successfully retire and the retirement work well for the owner (or former owner) and business?
What sort of planning might be appropriate for realty used in the business? For example, if the realty is not inside corporate solution, should the realty be gifted via, for example, a family limited partnership designed to achieve gift tax valuation discounts? While the sale of the business may necessitate realty sale or lease issues, should the owner consider keeping the realty within his/her family and selling the business without the real estate?
Could the owner structure a sale of the business after an out-of-state move, so as to minimize or avoid state tax gain on the sale of the business? Realty gain within the state would ordinarily be taxed by the state, but sales of ownership interests are more complex from a state tax planning standpoint.
In conjunction with the sale of the business, could the owner structure a like-kind exchange of realty with a view to avoiding current gain?
Year-end planning has much emphasis on the short-term, but it is also an ideal time to blend in such long-term matters as exit planning. The most successful exit planning usually begins early.
Mike Pusey, CPA served as National Tax Director at Rojas & Associates. He has a BBA and Master of Science in Accounting from Texas Tech where he graduated with honors. He planned to be an accounting professor and worked a year on the Ph. D. at the University of Arizona before beginning his career at KPMG Peat Marwick, where he worked in...