According to a 2023 survey by the Exit Planning Institute, nearly three-fourths of the privately held businesses in the US plan some sort of ownership transition by 2033. Either by selling to an outside buyer, an internal buyout by employees or a planned successor, a merger, or some other means, many business owners are facing the need to cash in on their years of hard work by transforming their equity in the business into investable cash.
Typically, such liquidity events are a once-in-a-lifetime occurrence for business owners. But a business sale also requires thoughtful tax planning to maximize the benefits to both sellers and others whom they intend to benefit from the transaction. Estate planning is also frequently a key consideration, and in order to take full advantage of their newly liberated assets, most, if not all, business owners need a post-transaction investment management plan.
Advance Planning Is Essential
At least six months before the liquidity event, and preferably much earlier, sellers should begin consulting with their tax, financial, and legal advisors to develop a comprehensive plan for managing the transaction to create optimal outcomes for the business owner. These conversations should ideally include not only the financial ramifications, but, also the emotional and legacy implications, especially for founders whose identity may be entwined with the business, If the business has been a longtime family enterprise, discussing the “now what?” is particularly important as both the owner/founder and the next generations form plans for the next phases.
Taxes May Be the Biggest Single Expense
Often, minimizing the share of sale proceeds handed over to the government—either at the time of the sale or in later years, via generational wealth transfer—is a key consideration in liquidity planning. Depending on the legal structure of the business and the specifics of the seller’s needs and intentions for benefits to be provided to others, tax planning may include several strategies:
- More favorable legal structures for the transaction, such as a Section 1202 qualified small business stock (QSBS) exclusion, which may allow the seller to exclude a portion of the capital gain realized by the sale of stock;
- Conversion from C-Corp to S-Corp to avoid double taxation;
- An installment sale arrangement to spread the tax liability over a period of years;
- A charitable remainder trust (CRT) that can defer taxes on capital gains and create an income stream;
- Recapitalizing and gifting shares to family members, trusts, or charities to remove future appreciation from the taxable estate before the transaction occurs.
- Involving tax and legal experts in these conversations as early as possible can allow the business owner to devise a strategy that best meets their needs.
Estate Planning and Liquidity Events
Because the structure of seller’s wealth will be materially altered by the sale of the business, revisions in their estate planning documents will almost always be advisable. Especially for high-net-worth families, wills, trusts, and other documents should be carefully reviewed and revised as needed. Further, if the buyout involves funding from life insurance products, operating agreements, buy-sell agreements, and all beneficiary designations should get a thorough review. The seller may wish to take a fresh look at annual and lifetime gifting strategies for maximum tax efficiency, and multigenerational family organizations should probably create or review governance structures to ensure that the family’s legacy is prepared to nurture future generations of leadership.
After the Sale: Investing Strategically
For some business owners, the sale of the business may generate investable assets in an amount to which they are not accustomed. Having a sound, long-term plan for investing the proceeds to accomplish the seller’s most important goals is vital. Whether the seller is focused on funding retirement, on covering education costs for children or grandchildren, on establishing a philanthropic legacy, or some other aim, investing the proceeds in ways that can set the seller up for success is an essential element. Liquidity planning, then, should also encompass an investment management strategy aligned with the seller’s needs, goals, and resources. Several important questions should be asked as the plan is developed, including (but not limited to):
- What are your short-term liquidity needs?
- What is your retirement timeframe (or, for those planning to retire immediately, “What level of funding is required for your desired retirement lifestyle?”);
- How much risk are you willing to accept to ensure appropriate future growth?
- What core values should your investments be able to support?
Moving from owning and managing a business to overseeing an investment program requires a fundamental shift in thinking: going from a focus on the business and its needs to holding a broadly diversified portfolio of assets designed to provide current or future income while continuing to grow to meet the needs of the coming years.
JFS Wealth Advisors, as a fiduciary investment and wealth manager, works with high-net-worth clients and their families to create strategies for wealth building and preservation that can provide strong financial foundations for business owners and those whom they desire to provide for. If you or someone you know is facing a future liquidity event, we would appreciate the opportunity for a conversation.
