Solve The 'Double Tax Buy-Sell' Problem

June 30, 2002 at 08:00 PM
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Solve The Double Tax Buy-Sell Problem
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All business owners share one problem in common. They eventually want a liquidity event.

Someday they will need to turn their business over to a buyer. There essentially are three prospective buyers–a family member, an inside buyer, or an outside buyer.

To be successful in the business market, you need to think like a business owner and help them understand the end game. There is one basic rule to business transition. If you understand this rule, you can do a lot of business.

"There is no such thing as new money."

What does that mean? Its simple–every business owner eventually will be bought out of their business with their own money. At first blush, this is a difficult concept to grasp, but once the concept sinks in, it becomes the key to your sale. When an outside buyer purchases the businesswhat do they use to pay for the purchase? They use the income stream the business would have created had the buyer never sold.

Whose money is that? Its the sellers money. This is the primary reason to use permanent life insurance in a business case. You use it to fund the owners exit strategy. If its his own money why not start planning now.

In order to explain this concept, you need to understand the taxation of a business transition. I call it "The $1.82 story." This may be a surprise to you, but the transition of a business is the most heavily taxed transaction in the tax code. The tax approaches 110% of the sale price of the business.

Heres why. If you sell your business for $1, how much will you net from the sale? If we assume it is a capital gains transaction, the tax rate will be between 20%-28% depending on the tax jurisdiction.

Lets assume the tax is 28% for our purposes, since I practice in California. This means our business owner will net $0.72. But what taxes did the buyer have to pay?

Whether I am working with a buyer or a seller I always ask my prospect this question, "Are there any other taxes that have to be paid?" Most prospects will say, "Nohow could there be? Buyers dont pay tax." And while this is absolutely true, in theory, it is not true in operation.

Here is why. When the buyer writes a check, where does the money come from to pay the seller? It either comes from accumulated capital or from financing. In either case, the buyer purchases the business on an earnings multiplier. They are expecting to recover their investment in 5-7 years.

If they are going to retain the business, they recover their capital as taxable business income. In a 45% corporate tax bracket how much income do they have to earn to receive $1.00 to recover their $1.00 of capital? Most clients will say $1.45.

But is it?

Lets look and see. If you earn $1.45, and pay a 45% tax, the tax is $0.65 and you net $.080. But $0.80 is not their original $1.00. So how much do you have to earn to net $1.00? You have to earn $1.82. You pay $0.82 of tax and net $1.00 of income.

Why is this important? Remember I mentioned that the purchase of a business is the most heavily taxed transaction in the code? Look at the taxes. The seller pays $0.28 and the buyer pays $0.82–add them up–thats $1.10 total taxes to transition a business worth $1.00.

You can help your clients in two ways. First, show them the price tag of this transaction–$1.10.

Second, we can reduce the price tag by restructuring the financial statement of the company. The fair market value of a company is usually determined by the book value plus any goodwill. By converting goodwill to deferred compensation, you convert double tax dollars to tax deductible dollars. Be careful, a lot of accountants dont think you can do this.

You might be thinking, But, this makes the seller pay ordinary income taxes instead of capital gains. That is correct–but if your seller nets the same amount either way, what does it matter? Especially if the overall transaction costs less.

Many sellers find it difficult to sell their business for top dollar–professional buyers often out-negotiate amateur sellers. But by restructuring the capitalization of the company, you can make the ultimate cost to the buyer less and often give the seller more.

In most cases the sale should be to an inside buyer, but why doesnt that always happen? It doesnt happen because the inside buyer often has no money to purchase the business.

So instead what happens is the seller increases the inside buyers compensation. The inside buyer then pays taxes on the additional income and turns around and pays it back to the seller as taxable capital gains. This is what we call the double tax buy-sell.

I ask business owners, "If I could show you how to sell your business for top dollar and avoid the double tax buysell would you be interested?"

Each of you has a unique opportunity to become a business transition specialist. You can help your clients make some or most of the purchase price tax deductible.

How? By structuring a deferred compensation plan as an offset to the goodwill. More important, the deferred compensation is the sellers own money.

If he took the cash from the business he would have to pay tax on it anyway. By setting up a deferred compensation plan for himself or for the inside buyer to offset the goodwill he does two things. First, he establishes a substantial wealth accumulation program for himself. And equally important–he ties the inside buyer to the business.

Keep in mind, sellers are always bought out with their own money. You can be a hero for your clients by showing them how to make some or most of the business tax deductible and at the same time tie the inside buyer to the business in order to increase the value of the business over time.

, CLU, MSFS, of BMI Consulting in Newport Beach, Calif., is an 18-year COT and 24-year TOT member. He may be reached via e-mail at [email protected]. This article is an abridged version of a presentation he gave at the MDRT meeting in Nashville.


Reproduced from National Underwriter Life & Health/Financial Services Edition, July 1, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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