In Part 1 of this blog, we covered the need for time and the questions you need to answer in your planning. Your answers to these questions will drive the options available for minimizing the overall income tax paid on your business’s annual taxable income and the cash paid to you for your ownership.
Big Thought for Exit Planning and Time
Remember the Big Thought from Part 1:
“Don’t limit yourself by thinking there are only set plans available that you’ve heard about. The financial benefits of ownership, management of the business, and ultimate control of who manages the company are different and should be treated differently. What plan you implement should be the result of what you want to do. You shouldn’t try to fit what you want into a certain box based on the rules of that box.”
Today, we will dive deeper into the critical issue of taxes.
Your Tax Comes to 120%
How do taxes kill your plan?
To be blunt, if your business is going to generate the cash to fund your exit, how much of every dollar made by the company should you give the government before you get paid? If you had options where the tax rate could be 57%, 48%, 44%, or 35%, which would you choose?
(No, 0% is not an option; remember to ask me about Puerto Rico.)
Most business owners aren’t presented with that choice. Many times, the owner is told by an advisor (lawyer, CPA, business consultant, next-door neighbor, social media, etc.) that they should do X. You won’t know what the taxes are until the tax return is done, and you won’t know that you’ve paid more than you could have.
The combined tax rate on your exit depends on the type of entity you have for income tax purposes:
- C corp
- S corp
- Partnership
- Proprietorship
And the structure of the deal:
- Purchase
- Bonus
- Redemption
- Other
State taxes (or lack thereof) also come into play, but most people can’t quickly move to another state.
It also depends on correctly implementing your structure in compliance with all tax and labor regulations and requirements. Failure to do so could result in taxes and penalties of up to (maybe even exceeding) 120% of the amount.
The more you pay in taxes, the less money you have available to pay incentives to keep employees, run the business, and pay for your exit.
What Choice Do You Have?
Using a bonus, purchase, or redemption strategy impacts your taxes no matter what your entity is taxed for income tax purposes. You also can (sometimes) change your business structure and impact the total taxes you pay at the end of the day. Your goal is to minimize the number of times each dollar gets taxed based on your facts.
The IRS sets the minimum tax you have to pay on income. However, it is more than happy to let you pay as much as you want to over that amount. You can have structures where you pay tax once, or you pay tax three (or more) times on each dollar the business earns. Depending on your choice, you can also add payroll, sales, use, and many other taxes.
Luckily, most advisors will steer you toward an option that only has the dollar taxed twice, with payroll taxes added to one of those times. That’s not as bad as it could be, but you could do better. Sometimes, you might be able to have the dollar taxed once with payroll taxes added. However, in many situations, you could have the dollar taxed once without anything added to it.
The bottom line is there are numerous important factors to consider when embarking on an exit plan. The skilled attorneys at Venn Law Group are here to help guide you throughout the exit planning process. Contact us today to schedule an initial consultation.
Next up, the silent killer of your exit plan. The owner.
Gary W. Smith is an attorney at Venn Law Group with over 20 years of experience providing legal counsel and innovative solutions to business owners and management teams. His focus areas include mergers and acquisitions, succession and exit planning, securities and capital structures, business structures, and tax. He excels at navigating the legal complexities of diverse industries ranging from professional services and IT infrastructure to manufacturing and real estate.
Gary W. Smith is an attorney at Venn Law Group with over 20 years of experience providing legal counsel and innovative solutions to business owners and management teams. His focus areas include mergers and acquisitions, succession and exit planning, securities and capital structures, business structures, and tax. He excels at navigating the legal complexities of diverse industries ranging from professional services and IT infrastructure to manufacturing and real estate.