The
“exit” for most business owners is the largest financial event of their
lives, and most principals use specialists for exit and tax advice. I
get it. During my exit, we went to our trusted accountant and attorney.
Later,
I realized that decision was costly to my team and me; we paid millions
of dollars in unnecessary taxes, money we could have saved if I knew then what I know now.
Let’s use the internal Management Buyout, or MBO, as an example since
it is the most prevalent exit strategy in the roofing contracting
industry.
Note:
Do not use these examples for other exits, as taxation differs in an
“external” exit strategy, such as a competitor or private equity sale.
An
MBO typically has three parties: the seller, the buyer, and Uncle Sam.
During an MBO exit, the company also pays for everything, so strong cash
flow is needed to finance the buyout.
This next story offers an
overview of a “Payroll Bonus” exit strategy. Ironically, this method is
how my team bought the company from the second-generation son of the
founder. I was sitting next to a specialty contractor at an event who
knew I was an exit planner. He proudly shared how he retired and sold
the company to his son.
He also mentioned he sold his S-Corp by
grossing up his son’s salary, and then his son bought the stock with
after-tax dollars. The father then pushed me to show how we could have
saved him money.
Against
my better judgment, I gave in to his persistence. I took a piece of
paper and sketched a hypothetical $1 million exit to demonstrate his
method.
- The son must earn $1.666 million to net $1 million
(40% tax on capital gains of $1.6 million = $1 million), not including
payroll and other burdens. The
son pays his dad $1 million for him to net $800,000 (20% tax on capital
gains) and does not include the Net Investment Income Tax or a State
Tax, assuming Dad has a very low stock basis.
See how this can approach taxes exceeding 55%, free of an Estate Tax burden for wealthier owners? (We call this the “Payroll Bonus” strategy outlined in the chart below.)
He seemed unsurprised by my 55% calculation and then asked what a
Beacon strategy would look like. I explained several of our strategies
could have reduced his tax liability to between 15% and 35%. I then saw
the blood drain out of his face.
For your understanding, please use the chart below to illustrate the bottom-line results.
- Remember, it is not how much you make but how much you keep.
- The chart uses the same company/valuation illustrated with four strategies.
- The bottom line is the “Net Proceeds Available to the Seller.”
- Note the bottom two lines that reflect the “Tax Yield” and “Percentage of the Proceeds Realized.”
- Which method would you choose for your exit and retirement?
- Morgan Stanley once said, “You must pay taxes, but no law says you gotta leave a tip.”
IRS Circular 230 Disclaimer: To ensure compliance with IRS Circular 230, any U.S. federal tax advice provided in this communication is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer (i) for the purpose of avoiding tax penalties that may be imposed on the recipient or any other taxpayer, or (ii) in promoting, marketing or recommending to another party a partnership or other entity, investment plan, arrangement or other transaction addressed herein.