To turn hard work into an enduring financial legacy as a business owner, it is important that you begin talking with your wealth advisor about 18 months before selling your business or completing a dividend recapitalization. Assembling a coordinated team of advisors, including experts in wealth management, estate planning, tax planning, and investment banking, is essential to achieving a coordinated approach to planning for the liquidity event.
Time is your most valuable resource—the earlier you start wealth planning, the more opportunities you have. Conversely, if you wait until the transaction is about to close, you may miss the opportunity to capitalize on some of the most valuable strategies and pay more taxes than necessary. Following are important things to consider pre-transaction.
How Will a Business Sale Impact My Financial Future?
Before you and your advisors can create a strategy for managing the wealth created from a sale, you need to identify your priorities and goals. This will include understanding how much capital is required to fund your lifestyle, as well as whether transferring wealth to loved ones or gifting money to charities are priorities.
A central part of this exercise is thinking about how you will balance your lifestyle needs versus secondary goals of wealth transfer and philanthropy. (Read more about quantifying the relationship between annual lifetime spending and excess funds.) Another important element is deciding whether you want to continue working after the transaction or whether you will count on your investment portfolio to generate a steady paycheck to support your lifestyle.
You do not want to feel rushed into making decisions that will likely have long-term consequences, and you do not want to be thinking about these things for the first time when you are in the midst of trying to sell or recapitalize your company.
Give yourself time to think through various scenarios and possibly engage family members in the process. Your wealth advisor will be able to guide you through this process and point out potential opportunities and pitfalls.
See Benefits of Personal Wealth Planning Before Selling Your Business
Why Does My Wealth Advisor Need Time to Assess My Business Sale?
You may want to get your personal wealth advisor involved about 18 months before your business sale to allow for time to assess the tax and cash flow timing consequences of potential transactions. This will also give your advisor time to create projections for how much after-tax wealth you will receive under a range of valuations and transaction structures.
Your advisors’ work to assess the deal structure is especially important for transactions that are not all-cash deals and involve equity compensation or earn-outs. You also want to give your wealth advisor adequate time to lay the groundwork for establishing any trusts, foundations, and other legal structures that will be used in executing your wealth-management strategy.
Whether the proceeds from a transaction are treated as long-term gains or ordinary income will have a significant effect on the overall tax exposure for the owners. The top federal long-term capital gain rate is 20% plus potential exposure to a 3.8% tax on investment income. In contrast, the top federal rate for ordinary income is currently 37%.
Wealth advisors can also help you understand elements of a purchase agreement that affect the ultimate value and timing of the liquidity, such as rollovers, vesting, and earn-outs.
Can I Benefit From a Valuation Discount When Transferring Business Shares?
One of the most powerful wealth-transfer strategies for owners of growing businesses is taking advantage of the pre-transaction “valuation discount,” an important consideration. The valuation discount is based on the premise that the value of the business before a transaction is often less than the value at which the company is sold.
When transferring shares of a company to children or other loved ones, the size of the gift for estate-tax purposes is based on the value of the shares at the time of the transfer. Any appreciation in the value of the shares that occurs after the transfer is not subject to estate or gift taxes. Thus, for companies that are growing, the earlier the shares are transferred, the more wealth the owner may be able to give to loved ones tax-free.
Timing is critical when it comes to taking advantage of a valuation discount. Often, when a company is sold through a merger or acquisition, or shares are sold through an equity recapitalization, the valuation used for the transaction is significantly higher than the pre-transaction valuation. If the owner wants to use the pre-transaction valuation for the gifts to loved ones, the transfer must have been completed before the owner signs the letter of intent for the business sale or recapitalization. After that letter has been signed, the valuation that is used for the transaction is likely the valuation that must be used for the gifts.
Is There a Downside to a Valuation Discount When Passing on Business Shares?
Although the valuation discount can be a powerful way to minimize wealth-transfer taxes, it is important to remember that transferring wealth before the transaction closes carries risk. To take advantage of the tax benefits of the valuation discount, the transfers need to be irrevocable—you can not undo them if the valuation or timing of the transaction end up being significantly different than what you had planned.
Market conditions may deteriorate, causing the buyer to lower the company’s valuation significantly or perhaps walk away from the deal altogether. In these situations, business owners may end up with much less wealth or liquidity than what they were anticipating. Conversely, a highly competitive sale process may result in a valuation that is significantly higher than what the owners had predicted when deciding how many shares to give to loved ones before the transaction. William Blair advisors have seen situations where owners’ efforts to limit the wealth transfer to their children were undermined when the valuation of the company skyrocketed during a highly competitive sale process.
Using scenario planning to see what the outcomes may look like under various sale prices can be an extremely valuable part of the pre-transaction planning process. Creating a dynamic financial model that allows you to adjust variables such as purchase price, tax treatment, rollover equity amounts, and return assumptions will serve as a useful tool in estimating net proceeds and how much, if any, excess wealth is available for secondary planning objectives.
What Else Can I Do to Build My Family Wealth?
In addition to tax considerations and the valuation discount, there are other ways to strengthen a family wealth legacy.
Teach Family Members to Be Good Stewards of Wealth
Creating an enduring family financial legacy is about much more than the amount of wealth that is passed to younger generations. It also involves teaching children and their offspring to be good stewards of the wealth and teaching them about the values that have defined the family and the history of the company. Bestowing these lessons does not happen by accident. The most successful families take a proactive approach, which can be as formal as holding annual family meetings and forming a family foundation. They can be as informal as having regular conversations about the history of the company and explaining the family’s role in contributing to the community.
Consider a Grantor Retained Annuity Trust
A grantor retained annuity trust (GRAT) is one of the most common vehicles used to transfer the future appreciation of the shares of a business to children without that appreciation being subject to estate or gift tax.
How Do I Make the Most of Philanthropy?
Many business owners are committed to investing in their communities. When philanthropic business owners are ready to sell their companies, charitable giving may be a central part of their long-term wealth planning strategies.
Business owners considering a sale should discuss their long-term philanthropic goals with their wealth advisor. The proceeds from the sale can be used to fund charitable vehicles that generate a tax deduction for the donor, such as donor-advised funds, private foundations, charitable trusts, or outright gifts of stock.
There may also be an opportunity to establish charitable vehicles ahead of a business sale or transaction that can avoid or reduce exposure to capital gains tax. Accelerating the donations into the year of the sale can help offset the taxable income generated by the sale of the company.
By contributing low-basis stock instead of making cash gifts, business owners are able to avoid recognizing capital gains on this stock. It is important to note, though, that the gift of stock must be made before a letter of intent to sell the company has been signed; otherwise, the owner may violate the anticipatory assignment of income doctrine, and the full tax benefits of the gift may not be realized. There are many vehicles and methods that business owners can use to maximize the impact of their charitable gifts. Each approach carries a unique set of advantages and disadvantages.