In working with business owners as they prepare to sell their businesses, I have noticed that they often neglect the important personal financial planning issues that emerge during and after a major liquidity event. This is also the time that significant planning opportunities arise requiring more sophisticated legal and tax work. If you own a business and are planning to sell it at some point in the future, these 5 financial planning areas are important to consider:
While it may seem like common sense, taking the time to talk about the life changing implications of a liquidity event are often ignored in the flurry of legal documents and issues to be addressed when negotiating a sale. Having these discussions are important for a number of reasons:
Your retirement plans. There may be ways to construct the deal to provide ongoing income to support you in retirement. One example is to continue to hold any real estate used by the company and receive rental income for several years into the future. Also consider whether the company has provided employment perks that you and your family value, like health insurance, and either make this part of the sales agreement or determine the best way to continue them in a cost- and tax-efficient manner after the sale.
Plan for major purchases. It’s also common for a business owner to want to celebrate a successful sale with a major purchase such as the car of their dreams or the vacation home they’ve always wanted. Before making an expensive purchase, it’s a good idea to talk this over with your spouse or partner in light of your other wants and needs.
Create a new vision for your future. If your proceeds will substantially increase your overall wealth, and financial security is now achieved, what are your new priorities? Are they the same for you and your spouse? These discussions begin at home, but it’s often helpful to enlist professional advisors to think through the details. Sometimes there’s a need to change or add additional advisors if you have significantly more net worth than you’re comfortable handling on your own.
Receiving a windfall often generates a desire to give back. There are many sophisticated giving techniques that can be incorporated depending on the nature of the business, titling of the entity, the amount of the sale, overall tax situation, and intended recipient of the donation.
Use a Donor Advised Fund. One of the easier options to implement is the use of a donor advised fund (DAF). Simply put, a DAF is an entity that allows donors to make charitable contributions, receive an immediate tax benefit and then distribute donations from the fund over a period of time. Typically, the maximum tax savings occurs if you gift shares of the company into the DAF before finalizing your business sale contract. That said, even if you make a gift post-closing, you still have the benefit of making a single deposit, getting a tax break, and then distributing funds to charities you wish to support in future years.
Fund College Savings Plans. Another common use of deal proceeds is to secure college funding for children or other family members. By utilizing 529 plans, you gain the benefit of tax-free growth if the assets are used for approved education expenses. Previously, 529 funds were available only for higher education, but the new tax law expanded 529 plan use to private K-12 tuition.
Business owners who are selling may want to make a lump sum contribution towards college savings. This can be done, keeping in mind that such contributions are treated as a gift subject to the current gift limit of $15,000 per beneficiary per person (i.e. $30,000 from parents per child). The tax laws allow you to make a one-time deposit that covers five years of gifting exemptions which means you can give a total of $75,000 per child ($150,000 for married couples). If a maximum lump sum contribution is made, then you cannot make any additional gifts to that beneficiary for five years.
This is particularly helpful when someone is in a high tax bracket where investing funds outside of a 529 plan would expose them to annual tax, perhaps at relatively high marginal tax rates. Pre-funding college for young children beneficiaries allows them to benefit from several years of compound interest and a longer time horizon for investment gains. For more information about 529 plans, read: What College Expenses Are Qualified and Other 529 Facts.
Having your CPA and attorney involved during sale negotiations will be important for helping you estimate tax implications of your sale. When tax liabilities are substantial, you’ll need to maintain cash reserves so you can meet the tax liability payment on time. If payments won’t be due for several months (i.e. you sell early in the calendar year and tax isn’t due until April 15 of the year following), we still suggest keeping the reserve in cash rather than putting the principal at risk in non-cash investments like the stock market.
In the year of your transaction, you’ll want to consider ways to accelerate expenses and defer income. Capital gains events, including selling property with a capital gain or selling appreciated stock, should be reviewed in light of higher marginal tax rates or how it impacts your alternative minimum tax. It may make sense to defer any elective transactions to a future tax year.
Once your deal is complete, you may need to begin paying quarterly tax estimates if there’s a dramatic change in your income from the prior year. This is where cash flow planning becomes important. Many business owners eliminate their compensation income or change the nature of how they are paid under new ownership which may require them to start filing and paying estimated taxes.
Selling your business may result in a significant increase in liquid personal assets once the sale closes. In addition to considering how to invest the funds, you may want to increase your existing personal umbrella liability coverage to the maximum level allowed. If that coverage is not enough, then you may want to consider an Excess Coverage policy. These policies serve as secondary coverage, meaning your original policy would be the first to pay any claims with the secondary paying claims in excess up to the secondary policy’s limit.
Equally important is determining how to redeploy key man policies you may have had as a business owner. Most often, these policies are owned by the business entity and they are the beneficiary if the key man passes away. If you were the primary owner of the entity, then you have the power to change both the ownership and beneficiary on these policies. That is an important detail to handle post-closing because if you don’t, the new business could receive a payout upon your death. Some of these transfers have tax implications, so you’ll want to consult a CPA before actually transferring ownership.
Lastly, titling non-retirement assets (i.e. proceeds from a sale) in the name of a trust may provide protection from future creditors, which is not available if you hold assets in your personal or joint name. This planning technique will require legal advice to establish the correct type of trust because some trusts, like a revocable living trust, do not protect your assets from your creditors.
Speaking of trusts, if your estate plan doesn’t already include the use of trusts, a liquidity event is a good time to consider this tool for effective estate and tax planning. As we outlined in Protecting Your Child’s Inheritance in Case of Divorce, trusts can have multiple benefits including: ensuring your wealth gets distributed in accordance with your intentions, protecting your heirs’ inheritance from becoming their spouse’s property should their marriage end in divorce, and providing an independent trustee to help in managing assets.
If you already have a trust in place, that means you’ve designated a trustee in the case of your disability or death. If your business sale yields a substantially higher amount of wealth that could end up in a trust accessible by children or other younger relatives, now is the time to consider whether the trustee you’ve appointed is appropriate for managing potentially higher amounts of money. There are many options for professional trustee services including local banks, trust companies or a trusted personal advisor such as a CPA or attorney.
Related, you’ll want to review stipulations for when funds are passed to beneficiaries. Many attorneys recommend staging distributions over the life of beneficiaries, perhaps ten years apart (i.e. at ages 30, 40, and final distribution at age 50) for amounts above those they would receive to support their living expenses. This staging gives the beneficiary time to gain experience in handling money and protects them from potential personal liability or loss of distributed assets in the case of divorce.
Lastly, although federal estate tax exclusion limits dramatically increased in the latest tax reform act, some advisors still recommend using trusts in estate planning for effective tax planning because current exclusion limits are scheduled to sunset at the end of 2025 and, in theory, could be changed even sooner if there’s a change of administration.
With any windfall, and especially with the sale of a business, planning ahead with the guidance of experienced advisors can help you avoid mistakes and prepare you to fully reap the benefits of your hard work.
Consider this your training manual to get and stay financially fit for life!