ELITE ADVISOR BEST PRACTICES

Exit Strategies

Too many business succession plans don’t work out as planned, but smart advisors can help clients get back on track and stay that way for the long-term.

By Elite Advisor Report interview with Guy Baker, BMI Consulting, and Tim Voorhees, Matsen Voorhees

Key Takeaways:

  • Most business owners create unnecessary risks for their families, employees and clients by failing to fund business succession plans.
  • Business owners can reduce the costs of succession plans by 50 percent if using pre-tax dollars to pay for insurance.
  • Instead of paying top marginal tax rates of more than 50 percent on extra business income, it is possible to take deductions now to fund insurance policies that grow tax-free and make tax-free payments during retirement and/or at death.
  • When considering the tax benefits of business succession strategies on top of the investment returns in good insurance policies, it is often possible to generate double-digit internal rates of return.
  • More important than the high after-tax IRRs is the peace of mind that comes from knowing that a business succession plan has been designed, drafted and funded properly.
  • Tax experts can recommend various tax-deductible buy-sell strategies, but Capital Split Dollar (CSD) may be the most attractive for many business owners.

As we head into the final months of the calendar year, many of your successful entrepreneur clients may be thinking that now is the right time to pull the trigger and exit their businesses. Unfortunately, business transitions don’t usually go as smoothly as expected, and the failure rate of succession plans is now at eyebrow-raising levels. But it doesn’t have to be this way, as explained by Elite Advisor Report columnists Tim Voorhees and Guy Baker.

Baker, managing director of BMI Consulting, is a longtime advisor to business and a co-developer of the Capital Split Dollar program. Voorhees is managing partner, Matsen Voorhees Law, and president, Family Office Services.

Tim, what motivates most business owners to think about a business succession plan?

Voorhees: Scary stories about failed companies motivate business owners to consider implementing a business succession plan. Despite the obvious need, few plans are actually designed, drafted and funded properly. High professional fees and insurance costs often take the blame when business owners are asked why they did not implement a succession plan. To overcome these concerns, wise advisers will motivate business owners to complete their plans by showing them how to fund all costs with tax savings.

Guy, why do so many succession plans miss the mark?

Baker: Most business succession plans fail. According to Harvard Business Review, only 30 percent of the businesses make it to Generation Two and a mere 3 percent survive to generate profits in Generation Three. Estate planning experts such as Perry Cochell, Rodney Zeeb and George Hester came up with similarly disappointing numbers. Given this dismal success record for family business transitions, it is no wonder that 65 percent of family wealth is lost by the second generation and 90 percent by the third generation. By the third generation, more than 90 percent of estate value is lost despite the efforts of well-meaning advisers. It does NOT have to be this way.

What is the biggest problem business owners face when they try to implement succession plans?

Voorhees: Unless business succession planning addresses tax issues, company owners can lose much of their wealth to taxes on income, capital gains, IRD, gifts, estates and other taxes. In most successful businesses, the company will generate taxable cash flow that exceeds what is needed to fund the owner’s lifestyle. This extra cash flow is then taxed at 50 percent or higher top marginal state and federal income tax rates. When the after-tax proceeds are invested, the growth is subject to 30 percent or higher capital gains rates (when taking into account state tax rates, the Medicare surtax and the phase-out of deductions). Ultimately, when the remaining assets are passed to family members or successor managers, there could be a 40 percent gift or estate taxes applied.

How can advisers help solve this tax problem?

Baker: To help solve this problem, every business owner should establish a clear vision for his or her transition and look for ways to improve after-tax returns. Tax-efficient planning strategies are needed to guide decisions about daily operations and business exit strategies. An astute adviser knows how to fund business succession agreements in ways that generate current income tax deductions while allowing the business to generate tax-free income for the business owner and/or successors.

What are some ways that advisers can help reduce taxes?

Voorhees: There are many tax-advantaged business succession techniques that give business owners a competitive edge. As noted on my Web site, qualified plans provide tax deductions in the current years, but they are not typically as tax-efficient for funding a buy-sell. More advanced planning strategies involving Section 79 and Section 162 plans can provide tax-free payments for the retiring executive or death benefits for family members, but limit the tax deductions when the plans are funded. There are very few options when an adviser seeks up-front tax deductions, tax-free growth and tax-free payments to the business owner and/or the owner’s heirs. At the top of the pyramid linked above is CSD.

Can you give us an example of how CSD works?

Baker: Take Thomas Smith, a successful business owner, as an example. He wants to lower his taxes this year and create a well-funded business continuity plan for his partners and family. He sees the importance of monitoring cash flow projections to identify unnecessary taxable income. His business can generate $500,000 annually in taxable income, but he needs only $300,000 annually pretax for his lifestyle. The extra $200,000 is wasted income and will be taxed at more than a 50 percent top marginal rate unless additional planning is done.

What can be done to mitigate the extra taxes?

Voorhees: Thomas’ advisers suggest a solution to reduce income and lower capital gains, estate, gift and other taxes. The advisory team shows Thomas how to offset $200,000 of income with a $200,000 tax deduction using life insurance. By creating a tax-deductible interest payment on a CSD loan, they can eliminate all of the unnecessary taxes. Assuming interest costs are 4 percent, a $200,000 annual interest payment will support a $5 million loan. Placed in a properly constructed life policy, the entire $5 million grows tax free and eventually provides tax-free loan distributions at retirement or provides a tax-free death benefit to Thomas’ family. Thomas can lock in interest rates at 4 percent for ten years while maintaining enough cash value in the policy to pay off the loan should interest rates start to increase. Because the loan has recourse to cash value in an insurance trust, the borrowed money does not have to appear as a liability on the balance sheet of Thomas’ company.

What does $200,000 actually provide in benefits?

Baker: A policy with $5 million of cash value will likely create a $15 million death benefit. Structured correctly, this death benefit can provide ample funds for successor managers (e.g., children) to buy the business from Thomas’ estate and leave the Smith family with $15 million in after-tax cash. If, however, Thomas lives to life expectancy or beyond, the cash value can provide tax-free income for both Thomas and his wife, while endowing a dynasty trust for future generations with the remaining death benefit.

Where do the Smiths get the premium dollars?

Voorhees: Instead of taking the $5 million from cash flow, the company can borrow all of the money needed for the above strategy. Thomas has no out-of-pocket costs for insurance. In a high-tax state, most of the interest costs are funded with money that would have been lost to taxes. By signing appropriate disclosures, Thomas can have insurance professionals pay the few plan design, drafting and funding fees. In short, Thomas can arrange for third parties to fund all legal and insurance costs for his plan. What Thomas pays out of pretax cash for interest is a small amount compared to the expected increase in after-tax retirement and death benefits.

What is the bottom line?

Baker: Advanced planning strategies allow business owners to fund business continuity plans more cost-effectively. Business owners should work with advisers who can design a plan that can convert extra taxable income into tax-free cash flow for retirement and/or the tax-free purchase of equity from the business owner’s estate. Once the plan has been designed, experienced attorneys will draft legal documents to facilitate the tax-efficient plan funding. This integration of design, drafting and funding helps ensure effective implementation of the strategy as well as proper realization of benefits under a variety of scenarios. A wise adviser can quantify how planning costs are just a small fraction of the expected benefits. More important, these financial benefits bring peace of mind to the business owner, his or her family, and key executives. Great clarity and confidence results from having a business continuity plan that has been designed properly, drafted effectively and funded tax-efficiently.


About the Author

Guy Baker, MBA, MSFS, CFP® is a financial advisor to business owners. He works to help owners find ways to reorganize their planning to achieve tax-efficient solutions to their succession, retirement and estate planning problems. Guy is a 34-year member of Top of the Table and recognized by Worth magazine as one of the top 250 financial advisors. For more information, you can contact him at guy@bmiconsulting.com or through www.bmiconsulting.com

Tim Voorhees, JD, MBA, is an estate planning lawyer and investment adviser based in Irvine, California. He is the president of the Registered Investment Advisory firm described at Voorhees Family Office Services.com and the managing partner of the tax law firm described at MatsenVoorhees.com. Feel free to email Tim at tim@vfos.com.

Readers of this document should consult with independent advisors regarding the tax, accounting and legal implications of the proposed strategies before any strategy is implemented. Nothing in this presentation is intended to offer securities or investment advice. Tax and regulatory rules affecting strategies in this document may change often and have varying interpretations. To ensure compliance with requirements imposed by the IRS under Circular 230, we inform you that any U.S. federal tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code or for promoting, marketing or recommending to another party any matters addressed herein.