Rick Ray

A Blueprint for Business Succession Planning

The equity that small business owners build in their companies represents a valuable personal asset. But in a privately-held company, how can equity be converted to liquid cash when the owner exits the business?  Creating an exit plan (or “succession plan”) is an integral part of strategic business planning. This article will help business owners understand: 1) why a succession plan is important; 2) how to begin the process; and 3) how to put the plan into action.

The Tax Impact at an Owner’s Exit

Succession planning aims to achieve an optimum outcome for the business (e.g., passing ownership to an heir or selling the company) while also converting business equity into liquid cash when it is needed. This goal is important for two reasons:

1. At retirement, business owners usually want to enjoy their leisure time or pursue other opportunities. After giving up control, they don’t want to worry about the health of a company they have left behind.
   
2. An owner’s heirs may lack the expertise or interest to manage the business. At the owner’s death, they would like to receive cash to increase their own personal financial security, and perhaps also to meet income and estate tax obligations. 

 

The value of a business passed to non-spouse heirs is included in the owner’s estate at death and could be subject to federal estate taxes. These taxes must be paid in cash, and the filing deadline for federal estate taxes is nine months after the date of death, unless an extension is requested. So, even if heirs do not need or expect a business to produce immediate cash after an owner’s death, federal and state governments require cash to settle taxes. In the worst cases, valuable businesses have been put on the market at “fire sale” prices just to meet estate tax pressures.

Aside from taxes, heirs may need cash for other needs including business debts and obligations, the cost of business appraisals, audits, and the cost of closing down the business and paying severance to employees. Almost every business needs a pool of liquid cash to work through a period of transition in ownership. Providing this cash is one of the most important steps in the succession planning process.

Three Key Questions

One starting point for business succession planning is to ask and answer three questions:

1. What is the business worth now on a “fair market value” basis? Fair market value is the amount that a willing buyer would pay a willing seller in an arm’s-length negotiated transaction. A business appraisal conducted by a qualified professional can help to answer this question.
   
2. What will the business be worth when the owner exits? Any future growth in revenues or profits should increase business value. Owners also can increase value by making provisions to groom one or more successors.
   
3. How will heirs obtain a fair value for the business when the owner exits? A solution called a buy-sell agreement pre-determines the terms of a sale (including transaction price) and also provides the cash necessary to complete the sale and pay expenses and taxes.

 

Terms of a Buy-Sell Agreement

A buy-sell may be formed between two co-owners or partners, who each agree to buy out the other’s interest. Alternatively, it may involve the current owner and a designated successor owner, perhaps a family member or top manager.

Most buy-sell participants lack the resources to pay “cash on the barrel” to buy a valuable business. Without planning, they may be capable of completing the transaction only by: 1) borrowing heavily; or 2) paying in installments over time. Since most business owners and their heirs prefer to receive cash at the closing, it is necessary to define the source of the cash well in advance. Often, the primary source is permanent life insurance.

Valuing the Business

After a successor is determined, the next step is to determine the buy-out value. While small business owners have some flexibility in setting the price of a buy-out transaction, the IRS and courts may insist on a valuation that represents fair market reality, as determined by an accepted method. The methods include:

• Comparable recent transactions – Business value is based on the terms of sales or mergers involving companies of comparable size in the same industry or market area.
  
• Multiple of revenue or book value – Business value may be pegged to a multiple of gross revenues in the year or two just before the owner exits. For example, many service-oriented businesses sell for about one to two times annual gross revenues. Or, the value may be pegged to an audited balance sheet as a multiple of “book value.”
  
• Discounted cash flow—The value is based on total cash flow that the business is projected to generate for a period of years (typically three to five) after the owner’s exit, discounted by a cost of capital.
  

Hire an Attorney to Draft a Legal Agreement

The next step is to formalize the buy/sell arrangement through a written agreement with the help of an attorney experienced in succession planning. Ideally, this attorney also has some proficiency in estate tax planning and business valuation. An important section of the agreement defines the “trigger events” that will require ownership to change hands. Common trigger events include an owner’s death, disability, retirement, divorce, or separation from employment. When a buyout is triggered by an event other than death, the legal agreement also may include provisions that prevent the departing owner from competing against the company or disclosing its trade secrets.

Provide Funding to Assure that the Agreement is Carried Out

Permanent life insurance typically is used to fund buy/sell arrangements because coverage can continue, and premiums remain affordable, at any age. Funding buy/sell arrangements with permanent life insurance also has other benefits:

• Quick and convenient cash for heirs – Life insurance solves the problem of turning an illiquid asset (the business) into liquid cash for heirs or estate settlement.
  
• Tax advantages – Life insurance pays a death benefit that is free of federal income taxes. In buy/sell arrangements, the benefit is usually paid to either a surviving party or else the company itself, so the death benefit does not create estate tax consequence for the estate of the deceased.
  
• Affordable, level premiums – Permanent life insurance can be purchased at affordable level premiums, especially when the insured person is fairly young and in good health.
  
• Cash value—The cash value of a permanent policy can provide buyout funds if an owner exits at a trigger event such as a divorce or normal retirement. Most agreements include provisions for terminating the buy/sell by mutual consent or if specified events occur. In this case, policy’s owner can recoup part of the premium cost from cash value.

Planning for a Long-Term Disability

In addition to an owner’s death, another trigger event that can be pre-funded with insurance is an owner’s long-term disability. In this case, disability income insurance can be purchased to fund an obligation written into the buy-sell agreement. This insurance pays to the beneficiary a stated amount of lump-sum or periodic income (after a waiting period) that can be used to fund part or all of a buyout.

In summary, business owners rarely stop working long enough to ask why they are working so hard. But there will come a day when this question will become paramount. Ultimately, a small business may not maximize long-term success for the owner and heirs unless the owner plans ahead to reap the rewards.

Federal Tax Incentives Encourage Small Business Retirement Plans

Too often, workers in small companies area much less likely to have retirement plan coverage on the job. The reasons are varied and complex, but they boil down to one basic problem. Many small companies don’t think they can afford retirement plans.

The U.S. Congress has addressed this attitude head-on by creating federal tax incentives that directly encourage small business retirement plans, while also reducing complexities that made plans costly or difficult to operate. As a result, the gap in plan participation between workers in big companies and small companies is starting to shrink.

Whether you own a small company or work as an employee in one, you should know about three basic areas of changes: 1) federal tax credits; 2) enhancements to SIMPLE plans; and 3) other incentives that make small business retirement plans more attractive.

Federal Tax Credits

Congress has created two federal tax credits related to retirement plans. One is specifically designed for companies with 100 or fewer employees that start new plans. These companies are eligible for a tax credit to offset a portion of administrative and participant education costs during the first three years of the plan’s life. The credit is capped at 50% of the first $1,000 spend on qualifying costs.

The second tax credit is available for low-income and middle-income participants in retirement plans of all types and sizes, including 401(k)s, SIMPLEs, Traditional IRAs and Roth IRAs. Taxpayers can receive a “government matching” credit on up to 50% of the first $2,000 of their own money they contribute to a plan. To qualify for the highest credit (50%), joint filers must have Adjusted Gross Incomes below $30,000 and single filers must fall below $15,000. Lesser credits are available for Adjusted Gross Incomes up to $50,000 joint or $25,000 single.

Enhancements to SIMPLEs

The SIMPLE, a type of retirement plan created specifically for small companies, was introduced by Congress in 1997.

The major advantage of SIMPLEs for companies is simplicity. By agreeing to make minimum contributions on behalf of all eligible workers, the company is relieved of responsibility for performing complex non-discrimination testing or complying with cumbersome “top-heavy” rules. When the SIMPLE plan is set up with personal IRAs as funding vehicles, the company also has no ongoing investment responsibility. After the first two years of participation, employees are free to transfer from the SIMPLE’s IRA into another IRA of their choice, if they wish, with no tax consequence or penalty. (A 25% premature distribution penalty applies on transfers in the first two years.)

Other Enhancements

Several other incentives in U.S. tax law have encouraged small companies to set up plans. A variety of funding limits have been gradually raised, ranging from 401(k) deferral limits to the formula for calculating defined benefit plan contributions. In general, small business owners will have more freedom to sock money away for their own retirements, with tax advantages. The top-heavy rules that have added red-tape for thousands of small companies in the past have been relaxed, too. Now, any matching contributions made by the company will count toward the minimum contributions required in top-heavy plans. Also, Congress has taken steps to increase the “portability” of retirement benefits among various types of plans. In the future, it will be easier for workers to take their plan money with them from job-to-job, or else transfer it into a personal IRA.

Now is a good time to review the many good reasons to create or participate in a retirement plan with the help of a qualified financial professional. The barriers that have prevented so many small companies from offering plans are falling. The opportunities of all workers to set money aside for the future, with tax advantages, have never been greater.

For further information email Rick Ray at: Rick_Ray@wealthdesigngroup.net

Next Week…A Blueprint for Business Succession Planning

Tax Deductions for Business Owners

When do you start hunting for tax deductions? If you are like most taxpayers, the answer may be around the IRS tax filing deadline. Often, that’s too late to make a difference.

Business owners have many opportunities to generate tax deductions throughout the year. Whether you are self-employed or run your own corporation, you can plan ahead to slim down your IRS bill by using the deductions described in this article.

• Home office deduction: You may deduct expenses allocated to the portion of your home that you use exclusively and regularly for business. To qualify, your home must be your principal place of business or be used to meet with clients in the normal course of business. If your home office qualifies, you can deduct a pro rata share of your total rent or mortgage interest payments, real estate taxes, depreciation, homeowner’s insurance and utilities.
  
  Planning Idea: It’s easier to qualify if you set aside a whole room exclusively for office use (not personal living needs). 

• Business Use of Automobile – Business owners commonly use personal cars to run work-related errands, visit clients, or buy supplies. The cost of commuting from your home to a separate office is not deductible. But if you qualify for the home office deduction (above), you can deduct the cost of traveling from a home office to any other work-related location. Two methods are available for calculating the deduction: 1) You may deduct a standard IRS-approved cost per mile; or 2) You may deduct the actual costs of vehicle operation based on the portion of total miles driven for business use. In most cases, mileage is the simpler calculation, but in either case the IRS requires you to document all business miles.
  
  Planning Idea: Keep a notebook in your car. For every business trip, log the starting and ending odometer readings, the business purpose and date.

• Gifts – If you give gifts to clients, such as a fruit basket at the holidays, the IRS allows you to deduct only $25 per person annually. However, with smart planning you may be able to increase the deduction. For example, you may deduct costs of wrapping, delivering or insuring gifts above the $25 limit.

Planning Idea: If a gift is intended to be used by a number of people, not an individual, you may be able to deduct more than the $25 limit. For example, suppose you regularly send a $100 holiday fruit basket to the president of a client firm. Only $25 is deductible. However, if you send the same basket to “all employees” of this firm, the full amount could be deductible (@ $25 per person). Consult a tax advisor for specific guidance.

• Employee Meals – If your business provides free meals for employees and does not include their value as taxable compensation, you generally may deduct only 50% of the cost. However, there is an exception called “meals for the convenience of the employer” that can increase the deduction to 100%. To qualify, you must show that free meals: 1) were consumed at a worksite; 2) were offered to at least half of all employees; and 3) met a business purpose, such as increasing productivity.

Planning Idea: If you regularly “order in” food for employees and pay for it, document on the receipt how many employees participated, the date and time, and the business purpose.

• Business Interest Expense – With the exception of the interest payments on a home mortgage, most personal interest is not deductible. However, 100% of the interest on business-related loans can be deductible. To claim this deduction, you should clearly separate business loans from personal by using a separate consumer credit account, credit card, or bank loan solely for business expenses.

Planning Idea: Suppose you are a sole proprietor and must take a loan to pay yourself a month’s salary. The interest on this loan will not be deductible. However, suppose that in the same month, you are paying cash for ordinary business expenses. Take a loan from an account earmarked for business and use it to pay ordinary business expenses. This interest will be deductible.
For more ideas on deductible business expenses, visit the IRS’ Web site at www.irs.gov and download a copy of Publication 535, Business Expenses. Also, talk to a qualified CPA or tax advisor well before the end of your business tax year, so you will have time to plan ahead for reducing your next tax bill.

For further information email Rick Ray at: Rick_Ray@wealthdesigngroup.net

Next Week…Federal Tax Incentives Encourage Small Business Retirement Plans

Rick Ray Joins the Houston Business Show with Innovative Presence

Richard (Rick) L. Ray of the Wealth Design Group will be doing a daily feature on www.HoustonBusinessShow.com of a stock market update. This update will be done with innovative avatar technology and Ray will be seen in life-like form giving lunch and end of market updates. Furthermore, Ray will be on every week with a monthly feature with members of his firm and on other weeks Wealth Design Group members will appear on other Houston Business Show panels.

The Wealth Design Group will have a significant daily and weekly presence on the Houston Business Show (M-F at 11 AM), it's website and the Houston Business Review website. The Houston Business Show is delighted to add this addition.

About Richard Ray

Richard (Rick) L. Ray's firm, Wealth Design Group, is one of the fastest growing firms in the Houston Metro Area. In 2007, Rick's firm qualified for GAMA International  IMA Diamond Award. Rick has been in the financial planning industry for 23 years. Rick has written (co-authored) one book, "Your Circle of Wealth".

Rick's professional credentials are as follows: He is Board Certified in Estate Planning, Insurance, Securities, and Taxation. He is a Certified Fund Specialist and a Certified Senior Advisor. Rick is also a Registered Financial Consultant with the IARFC. Rick has also earned a Masters Degree in Financial Services. Rick is a Registered Financial Advisor with the National Football League Players Association. Rick's passion to work with professional athletes comes from his career as a successful coach and athlete. Before entering this field, Rick coached at Northeast Louisiana. As a high school coach, Rick was awarded the AAAA Louisiana Sportswriters Association Coach of the Year after he turned around a 0-30 football team and led them to the state semifinals in his first year as the schools Head Coach.

Rick graduated from Northwestern La. University as a Cum Laude Graduate with a Bachelor of Science Degree in Education. Rick then earned his Masters Degree in Exercise Physiology from University of LA, Monroe.

Rick is married and has two children. He is a member of Sugar Creek Baptist Church and the Houstonian Golf Club. Rick is an avid scuba diver and currently holds the Master Diver Certification. In 2006, Rick and his wife, Tara, started the Ray Family Foundation.