When discussing business succession strategies with your clients, remind them that there’s no such thing as new money. Every owner will get bought out of their business with their own money whether they do an asset sale, an insider sale or sell to an outside buyer. There are various methods for determining the price–appraisal, capitalization of net income, multiple of sales, book value or comparison to similar companies that have recently sold. But no one buys a business for an amount greater than four to five times net income. Buyers want to pay off the purchase within a few short years.
If a buyer pays all cash for a business, that sounds great. But they’re really just advancing the owner on the money they expect to earn after taking over the business. Whose money do they expect to earn? The seller’s! Think of it this way. If your client hadn’t sold their business, they would have probably earned the money that the new owners are going to turn around and give back to them. Worse, buyers sometimes make it a contingency sale. That means they pay a small amount upfront, but the bulk of the proceeds are withheld until they see how the company performs without the original owner at the helm. This gives the seller an incentive to make the deal work. But where did the money come from to buy out your client? Once again, it was your client’s money.
Whether the payment is cash from liquidation of assets, borrowed funds, a private offering or an installment sale funded from cash flow, the results are always the same. It’s a reflection of the income the company would have earned. The outside buyer is simply a facilitator. All they did was turn around and give your client their money back. Granted, they may have taken some of the risk out the deal, but in the final analysis, it was your client’s money they used to buy their business. And when it’s over, what does the seller have to show for it? Nothing other than the net proceeds from the sale.
But with the right planning in place—preferably five or more years in advance of the sale—owners can start moving some of their money out of the business while time is on their side. Ultimately, they can get much more value out of their business than they ever thought possible.
Making the decision to diversify risk and cash flow, however, is very hard for many owners to do. They’re always fighting the cash flow boogie man. They get nervous about making long-term commitments to a wealth accumulation plan. Why? Because there’s the lingering fear that they’ll need the money for day-to-day operations and for emergencies if the business cycle turns on them. But unless your client’s business is fighting for survival, the owner’s money should be the very last source of capital, not the first. To that end, there are three smart strategies that owners can use to retain more wealth from their business while time is still on their side.
1. Captives — Many companies have risks that are uninsurable. If an uninsured event occurs, it could destroy the company. These risks are unique to each company. Congress authorized the formation of small captive insurance companies to help fund these risks. There are specific rules about forming captives. In general, they can be used primarily as tax shelters, and the tax advantages can be significant. The rules allow companies to make deposits into a tax-exempt entity called a captive company. All the money accumulated in the company is invested and reserved in case of a claim. But if the claim never materializes, the assets remain in the captive and increase in value as the captive grows. Because the premiums paid by the owner are tax deductible, a captive can be a significant long-term wealth accumulation tool for the owner(s).
Just make sure you and your client consult with an expert on captives because there are limitations and rules your client must follow. There are also administration costs and reinsurance costs annually. But the setup cost is about 5% compared to a tax cost of 40% on the premium. Even better, when the captive company is liquidated, the retained earnings are taxed as capital gains rather than as ordinary income, which is significant benefit.
2. Long-term care insurance (LTCI) — Statistics show that half of Americans who reach age 70 are likely to need some type of special elder care before they die. As the cost of elder care rises faster than inflation and most other types of healthcare, LTC for the elderly is a growing concern. That’s why LTCI is becoming increasingly important as a benefit for key executives. Most affluent families would rather stay in their homes than go to a senior housing facility. Medicare and Medicare supplements don’t currently cover daily home care. What’s the best way to finance these health care costs?
Based on my experience, the best way to cover costs, which can last two and a half years on average, is to purchase LTCI. These plans pay a monthly that can be used to pay for any type of services at home or in a care facility. The benefit payments are income tax-free, and the premiums are tax-deductible if paid by the corporation. Owners can also pick and choose which employees they wish to cover. Unlike Internal Revenue Code Section 401(k)s and other worker benefits, LTCI doesn’t have to be offered to all employees.
When you consider that 10% of all healthcare spending in the U.S. goes to end-of-life care, LTCI protects the family’s wealth from liquidation and guarantees the family income isn’t going to be dissipated for health care to the detriment of the non-infirmed spouse. I’ve seen the wealthy lay off the risk of LTC to an insurance policy. They understand the principle of insurance and have decided to not take the risk personally. They see it as a hedge against risk.
3. Capital split dollar (CSD) — An alternative to selling stock or putting in a qualified plan for your key employees is to implement a CSD benefit plan. This strategy calls for the company to lend significant premiums to the executives for a period of 10 to 15 years. The money is invested in a capital rich insurance policy that’s designed for maximum accumulation. The cash account grows tax-free until the executive is ready to borrow from the account during retirement. If the corporation borrows the capital for the plan, the interest on the loan is deductible, making CSD the only leveraged program with tax deductible interest.
Dr. Guy Baker, CFP, Ph.D is the founder of Wealth Teams Alliance (Irvine, CA). He is a member of the Forbes 250 Top Financial Security Professionals List and author of Maximize the RedZone, a guide for business owners as well as The Great Wealth Erosion, Manage Markets, Not Stocks and Investment Alchemy. He received the 2019 John Newton Russell Memorial Award for lifetime achievement in the insurance