Every business owner knows that he or
she will eventually exit the business.
However, they often fail to properly plan their exit strategy, and that can have
major repercussions.
One specific issue that should be
addressed as part of any exit plan is how
business income should be taxed upon the
owner’s departure. After all, the form of tax
entity that is chosen will have a major
impact on future outlays to Uncle Sam.
“The structure of the ultimate sale of the
business will determine to a great extent
how much tax you pay,” points out Carl
Pon, co-managing partner of Vicenti, Lloyd
& Stutzman LLP. “Failing to plan could
actually double the amount of income
taxes that you pay upon the sale of your
business.”
Smart Business spoke with Pon about
the importance of exit planning, what factors to consider when choosing a tax entity and the consequences of operating
under the wrong tax entity.
From an income tax perspective, why is it so
important for business owners to plan for
their eventual departure?
We see many clients who spend their
adult lives building a business and building
wealth inside that business. Then, when it
is time to sell that business, they are surprised to see how much the tax burden
reduces what is left to invest to provide for
their financial security and that of their
families. With proper planning, you can
reduce the share of the take that goes to
the taxing authorities.
What factors should be considered when
choosing a tax entity?
Some of the factors that should be considered include: Who will own the business
— will it be individuals, trusts or other corporations? Will there be any non-United
States taxpayers? How important is it to have the current benefit of lower tax
brackets? What kind of fringe benefit plans
will be offered to owner-employees?
What are the consequences of operating
under the wrong tax entity?
The most obvious one would be paying
too much in income taxes. But another
consequence is that you will have to wait
longer to accumulate the wealth that you
need to achieve your personal goals. In
fact, it is conceivable that operating under
the wrong tax entity could double the
amount of time that it would take to
achieve these goals.
How do the tax structures of C Corporations
and S Corporations differ?
A C Corporation is a taxpayer all unto
itself and it has its own set of tax brackets,
some of which are lower than personal
income tax brackets. An S Corporation
doesn’t pay any income tax itself; rather, its
shareholders pay taxes on their personal
tax returns on the S Corporation income.
The biggest tax advantage with an S
Corporation is that you avoid taxes at the
corporate level, depending on when you
made the election to become an S
Corporation.
What type of entity is most effective when
transferring a business to family members or
key employees?
They are all just about the same except the
S Corporation, which is a little more difficult
to use. This is because an S Corporation is
not allowed to have more than a single class
of stock or ownership interest.
Several of the techniques for transferring
wealth most tax efficiently involve creating
two types of ownership interests for the
same business. You can do that with C
Corporations or LLCs, but it is much more
difficult to achieve the same effect with S
Corporations.
How far in advance of an anticipated departure should exit planning occur?
I would say five years to get the largest
benefit from the planning process and to
implement what the plan identifies as the
things you want to accomplish. If you’re
looking at a conversion from a C
Corporation to an S Corporation, then 10
years is the best timeline to work with.
What should be discussed with advisers
when planning for an exit?
Early in the process, you should focus on
setting your personal goals and identifying
strategy changes to increase the value of
your business. Also, you should develop a
contingency plan for the business and
assemble a team of advisers. The team
should include an attorney, CPA, exit planning specialist and financial planner.
CARL PON is co-managing partner of Vicenti, Lloyd & Stutzman
LLP. Reach him at [email protected].