Close Menu

Oxford Financial Group, LTD


Oxford Financial Group, LTD


Expert Perspective

News, research and market insights from our team of experts.


Current Issue | December 20, 2018

Business Exit Planning: The Many Costs of Delay

By: Julia Weaver, J.D., Director, Family Office Services and The Trust Company of Oxford

The options for exit planning are vast. As explained by Oxford Financial Group, Ltd. Managing Director, Lorelei Tolson in the following video, exit planning can be as onerous as the infamous Swindon roundabout in London, with many unexpected twists and turns that can challenge the best of plans. It is, however, quite common for a business owner to have the vast majority of their wealth embedded within their business. As such, their time and effort is well rewarded, as their greatest wealth maximization tool may be a well-crafted exit strategy.

An undisputable truth in exit planning is that there are tremendous costs associated with delay. Whether a business owner intends to transfer interest to key employees or partners or sell to a strategic or financial buyer, there are hard and soft costs in delaying critical pre-transfer planning. These costs may be summarized as follows:

  • The increased cost of monetizing the business interest
  • The increased cost of funding a Buy-Sell Agreement
  • The cost of unnecessary stress on business operations
  • Valuation detractors for failing to prepare the entity for due diligence
  • The lost opportunity to mitigate taxes
  • The cost of failing to partake of low interest rates that amplify tax savings
  • The lost opportunity to convert the entity structure for maximum tax efficiencies
  • Failure to take advantage of current tax laws highly favorable to tax-saving strategies

Increased cost of monetizing the business interest
There are two primary ways an entity may raise cash in order to monetize the business interest: debt financing or equity financing. When an exit strategy involves debt financing or any use of leverage, the historically low current interest rates create very attractive options for closely held businesses.

Where possible, accelerating exit planning to take advantage of the low current financing costs can provide meaningful savings to the entity in the case of a leveraged redemption or leveraged recapitalization. A leveraged recapitalization is a strategy by which an entity uses leverage to pay a cash dividend to shareholders or to re-purchase some of its own shares. It can provide an excellent means for an owner to take chips off the table for wealth diversification purposes and as part of an overall exit plan.

Low interest rates also serve to reduce a buyer's cost, thereby fueling robust M&A activity and enhancing a seller's negotiating position. As aptly stated in a RBS Middle Market M&A Outlook report, "[a] unique set of factors has coalesced to form a "perfect storm" of M&A activity; a[n]... improving economy, historically low interest rates, and a strong appetite among many businesses for growth through acquisitions." Failing to explore the opportunities in the current environment could result in a loss of future enterprise value for business owners.

Increased cost of funding a Buy-Sell Agreement
A Buy-Sell Agreement is an agreement that defines the circumstances under which ownership and control of the entity will change upon the occurrence of certain events such as death, disability and retirement. If properly funded, the Buy-Sell Agreement can guarantee a market for the sale of business interest and a smooth transition of ownership. Without adequate funding, such as key man life insurance, the purchase obligations within a buy-sell agreement can be wholly meaningless and unenforceable.

Insurance on the lives of the shareholders should be put in place as soon as the business has meaningful value, regardless of the identity of the ultimate buyer. The ownership of the policy and beneficiary designations should be coordinated with the comprehensive exit strategy and owner's estate plan. Without life insurance funding, much flexibility may be lost. If delayed, mortality risks and health concerns can cause the price of this option to increase and, in some cases, become cost prohibitive.

The cost of unnecessary stress on business operations
Another cost of delay in exit planning is the potential disruption to the business operations after a transition of ownership. During this fragile time in the business, key employees often become insecure and can end up being the biggest competitor of the ongoing entity. Key customers may become equally insecure, compounding the disruption to operations and cash flow. Much of this risk can be mitigated by a contingency plan that provides for the following key planning provisions:

  • A retention plan for key employees, including non-compete agreements and possibly deferred compensation, long-term incentive plans or other non-qualified benefit packages
  • A strong management succession plan
  • A clear and defined communication plan for retention of key customers

Valuation detractors for failing to prepare the entity for due diligence
Securing the maximum enterprise value from the sale of an entity requires acute attention to the internal business operations that will be scrutinized in the due diligence process, which typically follows an initial Letter of Intent or Purchase Agreement. Most advisors cite a two year period as the optimal time frame with which to shore up an entity's books and records and to perform any restructuring that will maximize the entity's enterprise value.

"Due diligence" is the process by which the buyer "inspects" the entity, and this will encompass a review of all corporate documents, accounting records, tax and financial statements, employment agreements, licenses and permits, environmental issues, vendor and customer agreements, lending and other material agreements, intellectual property protections and all pending disputes and litigation. Business owners can avoid valuation detractors (which can cause reductions in a final purchase price) by preparing the entity for a seamless due diligence process.

Lost Opportunities to Mitigate Taxes
Taxes play a tremendous role in the accumulation of wealth and there are several pre-transfer planning techniques that can provide significant tax savings. However, many of these planning strategies require a period of time, as much as two to five years, to execute and to pass muster with the IRS. Hence, the longer an owner delays planning, the fewer the tax savings options.

An "estate freeze" is an example of this type of pre-transfer planning. The goal of this strategy is to "freeze" the value of a business interest at its current value for estate tax purposes. Any future appreciation after such planning avoids federal estate tax (FET)i.

When the asset to be transferred is an interest in a closely held business, the benefit of the "freeze" can be further leveraged with valuation discounts, available for minority interest and when there are restricted rights, such as a lack of voting rights or restrictions on transfer. These restrictions result in a business valuation that is significantly less than the value of the underlying assets.

As an example, a business owner may consider a partial transfer of non-voting interest to his or her heirs prior to the sale of the entity. The goal is to transfer as much wealth as possible (and not control) using up the least amount of exemption, i.e. leveraging the limited exemption.

Consider a business that has a value today of $15,000,000 and assume the following:

  • The business will be sold in five years for $20,000,000
  • The owner, today, transfers a 30% minority interest to his or her children, either outright or in trust
  • This interest (non-voting and subject to numerous restrictions) is hypothetically entitled to a 30% valuation discount

In this rudimentary example, the owner would use $3,150,000 of his or her gift and estate tax exemption for this transfer. Upon the subsequent sale of the business, the value now held by the children or family trust is 30% of the total sales price, or $6,000,000. The "pop" in value of $2,850,000 now avoids transfer tax. The estate tax savings from this transaction alone would be over $1,250,000... wealth now in the hands of the business owner's family and NOT the IRS.

Several planning strategies are designed to zero out the use of any of the estate tax exemption and can be further detailed and modeled by your team of Oxford advisors. Pre-transfer planning is critical. Many of these tax savings strategies are only available when there is a sufficient amount of time between the pre-transfer plan and the sale of the business. A tax advisor should be consulted to further advise on this and other similar strategies.

The cost of failing to partake of low interest rates that amplify tax savings
Low interest rates amplify the advantages of many pre-transfer planning techniques. When an asset is transferred in order to accomplish an estate freeze, as described above, the IRS requires a portion be "paid back" to the business owner, either as note payments (in the case of a sale arrangement) or annuity payments (in the case of certain transfers to trust). The rate that must be charged on these payments is referred to as the "hurdle rate".

When the appreciation of the transferred asset exceeds its "hurdle rate", the excess appreciation passes free of transfer tax. The lower the hurdle rate, the greater the amount of wealth transferred free of transfer tax. As such, low interest rates create the ideal environment for this type of pre-transfer planning and can significantly enhance the final tax savings.

Lost opportunity to convert the entity structure for maximum tax efficiencies
A business should be intentionally structured to maximize the tax efficiency of the exit strategy. The difference between being structured as a Subchapter S versus a C corporation can highly impact a business owner's tax obligation. For example, an asset purchase, rather than a stock purchase, is typically more desirable to a buyer. In an asset purchase, buyers are generally able to step-up the basis of the acquired assets and thereby potentially take depreciation deductions on those assets. Additionally, a buyer is able to better avoid latent liabilities that may be assumed with a stock purchase.

If the entity is a C corporation, however, the seller faces double taxation with an asset purchase arrangement. The corporation is first taxed on selling the assets to the buyer. The owner is then taxed again when the proceeds are distributed out to the owner. Notably, owners of S corporation interest avoid this double tax result and generally only pay capital gains tax on the amounts over their basis.

Consequently, the owners of C corporations may consider converting from a C to an S corporation as part of their pre-transfer planning strategy. This process, however, comes with an inherent waiting period before the gains will avoid the double taxation result. The PATH Act finally gave us permanence for this recognition period, reducing it from ten years to five years. C corporation owners would be wise to trigger the start of the five year period in anticipation of a well-planned exit strategy.

Other types of succession planning techniques may favor other corporate structures. For example, C corporations have a greater tax advantage than S corporations when selling stock to an Employee Stock Option Plan ("ESOP").

A corporate conversion or restructuring will not only require a period of time to attain full tax advantage, ample time should also be afforded for consultation, due diligence and implementation by the owner's team of advisors.

Failure to take advantage of current tax laws highly favorable to tax-saving strategies
Several proposals for tax reform have called for restrictions on certain highly effective planning options. For example, one key strategy for pre-transfer planning utilizes a trust called an Intentionally Defective Grantor Trust (IDGT) (pronounced "idget"). With this strategy, business interest can be sold to a trust for the benefit of heirs (and thereby removed from the owner's estate for estate tax purposes), but will not, unlike any other sales transactions, trigger immediate recognition of capital gains. This highly effective technique has been the subject of scrutiny by the IRS as well as the current administration.

Additionally, the use of valuation discounts, as described above, has been the subject of possible attack, potentially through regulations that would curtail discounts for certain intra-family transfers.

Grantor Retained Annuity Trusts (GRATs) are another technique used to freeze the value of a business interest by transferring the business interest into a trust that pays an annuity payment back to the Grantor for a designated term. A GRAT strategy can be designed to limit the use of the estate tax exemption, thereby preserving the exemption for other transfers of wealth. Several proposals have suggested restrictions that would curtail the tax savings impact of certain GRAT strategies.

These proposed changes would typically apply prospectively to new trusts created after any enactment date. As such, a business owner would be wise to consider these highly tax advantageous techniques while they remain available.

Final Thoughts
As with all elements of wealth planning, exit planning is a team sport and should be done in coordination with the owner's comprehensive estate plan. With proper time for pre-transfer planning, ideally two to five years, the business owner's team of advisors can craft a sound strategy to maximize enterprise value, disinherit the IRS where possible and assure that their overall wealth passes according to their legacy goals and objectives. Your Oxford advisors and the Swindon Transition Counsel can maneuver the twists and turns of the exit process, providing support and subject matter expertise in crafting the optimal exit plan.

iThe FET exemption for 2016 is $5,450,000 per person, or $10,900,000 per married couple. A transfer tax of 40% is imposed on any gift or estate in excess of this exemption.

This information is not intended to serve as tax or legal advice. As always, tax and legal counsel should be engaged before taking any action.