Long before owners want to retire, perpetuation planning should begin. The four major techniques to transfer ownership of a business are:
- Internal sale to key employees, including family members.
- Sale of the business to an outside firm.
- Merging with another agency with plans to eventually sell to the new partners.
- Passing the ownership to family or friends through inheritance.
A quick review of these four techniques shows that a perpetuation plan can either be internal or external. One should be chosen as the primary plan and another as the secondary. This article describes internal perpetuation options.
The Pros and Cons
The successful internal transition of a business requires planning for the founding owners’ retirement, death or disability. Without a good plan, the fate of the business is up to the whim of outside influences, such as the courts. Also, the lack of any plan may create a situation that will drastically lower the equity or value of the firm, thereby not preserving the family wealth.
Internal perpetuation is usually the most risky form of perpetuation. Recent statistics indicate that only 35 percent of family businesses survive past the first generation of ownership and about 20 percent survive to the third generation.
There are many reasons why small businesses do not always successfully pass down through the generations. Sometimes no family member wants to, or is able to manage the business. Not everyone is an entrepreneur capable of running a business successfully. This also applies to non-family employees as well. Typically, however, internal perpetuation fails because the buyers cannot afford to handle the buy-out.
For an insurance agency, there are some techniques that can be used to minimize taxes and ensure that the pay-out does not break the business. Like anything else that is worthwhile, these techniques will require planning and usually reduce the retiring owner’s return on equity. For many owners, however, the end results of successfully passing the business to the next generation are more desirable than the sales price or the pay-out terms.
Pass Control Efficiently
There are numerous options for passing the business to the next generation. The three most common are gifting, stock redemption and stock purchase. There are also many other tools, such as trusts that add to the variations that can be used to transfer business ownership.
Which “tools” are used and how the transfer is structured is based on three things: minimizing taxes, making sure it is affordable and ensuring that the seller has an adequate income stream. It is important, however, that the sale must be treated as an arm’s-length sale in order to avoid the IRS perceiving it as a gift or a “bargain sale.”
Create a Deferred Liability
Establishing a deferred compensation plan is a tool one can use to lower the value of the firm in order to make the purchase affordable for the new owners. Deferred compensation is a way of saying that you are not currently receiving fair compensation for one’s current work and it is planned to take it out at a later date.
The deferred compensation becomes a liability on the firm’s balance sheet, since it is a debt that must be paid. Because it is a liability, the value of the firm is lowered by that amount.
There are two uses for this plan: 1) the owner’s deferred compensation and 2) a producer’s deferred compensation.
Owner Deferred Compensation
The firm needs to file with the state that it is establishing a deferred compensation plan. This should be done years in advance of retirement. The plan can be funded or unfunded. However, for lowering the value of the firm it should not be funded. Since the deferred compensation is treated as regular compensation, it becomes deductible.
The retiring owner receives their equity in two components: the value of their business interest and the deferred compensation. The drawback is the deferred compensation is taxed as ordinary income (currently most people are in the 25 percent to maximum of 39.6 percent federal tax brackets alone, depending on their compensation plus payroll taxes), whereas, the income from the sale of the business is taxed as capital gains (which can be a 20 percent rate now for federal taxes if in the highest tax brackets or lower if in other brackets).
Producer Deferred Compensation
In the insurance industry it is an acceptable practice for a producer to own their book of business. An axiom in business valuation is that one cannot sell what they don’t own. Therefore, producer-owned books of business are usually excluded in the valuation of an agency. This technique can be used for relatives as well as non-related employees.
First, the producer/heir signs a regular producer contract as an employee of the agency. This contract includes a clause that allows the producer/heir to own the accounts that they produce. This way the next generation is not paying for their own effort (the book produced) and the cost of buying the agency is effectively reduced.
The drawback to the retiring owner is that their equity in the business is reduced. On the other hand, taxes are minimized (due to the lower value), and the buy-out is less likely to cause a drain on the business. The heirs will also not resent having to pay for their efforts since their books are excluded from the value of the firm.
TO BE CONTINUED: Other perpetuation options commonly used will be explored next month in the “Minding Your Business” column, stay tuned.
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