Last month, we discussed how the top line of a transaction (the sale price), isn’t the only thing a business seller should be focusing on. Ultimately, minimizing the tax impact will maximize the proceeds of any business sale. Many readers of our e-newsletter were intrigued by this idea— especially intrigued that proper tax planning could boost the usable transaction proceeds by up to 40%.
So this month, we’re presenting a case study, courtesy of our business colleagues at J. P. Morgan Securities. “It’ll have a bit more facts and figures, but we think it can give our readers a more solid understanding of what’s possible from a business sale,” says Achim Neumann, President of A Neumann & Associates, New Jersey.
Jim Smith, age 60, is married with 2 children and 4 grandchildren. He is a resident of New Jersey. Before the sale, his annual salary is $500,000 (pre-tax) per year. Besides the business, Jim owns a primary residence worth about $1 million, and has an investment portfolio of $2 million (75% Short-term Bonds, 25% Cash). He and his wife currently spend about $250,000 per year (after tax).
At retirement, the Smiths have three main goals: First, they want to be able to continue their current spending levels (adjusted annually for inflation) for at least the next 30 years. Second, they want to donate at least $300k to their favorite charity. Finally, they’d like to leave a financial legacy for their children and grandchildren of at least $7.5 million.
They hope that selling their business can help them achieve their goals. To that end, they’ve accepted a deal to sell their business for $10 million (pre-tax) as of June 30, 2012. Of that, they receive $8 million in cash and a 5-year, $2 million amortizing note at 8%. Because Jim started the business from scratch, it has $0 cost basis. He is keeping the commercial real estate, valued at $2 million and generating $120,000 rent (net) per year. For planning purposes, we assume that the spending needs and the rental income from the commercial real estate will grow at an expected inflation rate of 3.25% per year.
First, let’s look at what would happen if the Smiths simply add the after-tax sale proceeds to their existing investment portfolio, from which they withdraw their annual spending needs. Because the portfolio is extremely conservative, as many portfolios of near-retirement investors are, the annual rate of return is expected to be less than 2 ¼%. There is a large first year infusion of cash resulting from the sale, and the 5-year note generates about $487,000 per year in principal and interest. But after that 5-year period, the only remaining income, the rental of the commercial real estate, is not enough to cover the anticipated spending needs, and the couple needs to dig into their portfolio. By the end of the 30 year planning period, the Smiths’ portfolio, once valued at over $9 million, will shrink to $2.8 million (and falling). They’ll still have their residence and the commercial property, but their value is uncertain. Their liquid assets aren’t nearly enough to meet their goals.
So what can the Smith’s do? One thing they can do is to change their investment portfolio to a less conservative one composed of 55% fixed income, 25% equities, and 20% alternative investment vehicles such as hedge funds, private equities, and commodities. This type of portfolio is still markedly conservative, and it can be constructed in such a way as to make the probability of undershooting goals very low (i.e., less than 5% chance of a “worst scenario”). By doing this, the Smiths can achieve a likely portfolio value of $15.2 million after 30 years, and even the worst scenario would produce a portfolio worth $6.5 million. Significantly better, but this still doesn’t meet their goals.
So here’s an option: From the proceeds of the business sale, the Smiths make two gifts. One is a $4 million gift to a “Dynasty” Trust for their heirs. Simply defined by Wikipedia, “A dynasty trust is a trust designed to avoid or minimize estate taxes being applied to great family wealth with each transfer to subsequent generations. By holding assets in the trust and making well-defined distributions to each generation, the entire wealth of the trust is not subject to estate taxes with the passage of each generation.” Normally, in order to get assets to their grandchildren, the Smiths would’ve had to give them to their children, after paying gift or estate taxes on the proceeds. Then, their children would need to give them to the Smiths’ grandchildren, incurring another set of gift or estate taxes. By funding a Dynasty Trust, those successive rounds of taxation can be avoided.
The second gift is $250,000 to a Donor Advised Fund. The Smiths get the full $250,000 tax deduction when they set up the fund, which they are able to manage over time on behalf of their favored charities.
After the two gifts, the Smiths are left with about $4 million in their portfolio ($2 million original portfolio + $6.3 million business sale proceeds – $4 million Dynasty Trust – $.25 million Donor Advised Fund). Under the expected investment returns of the less conservative asset allocation, the Smiths would expect their portfolio to be worth $4.8 million in 30 years. Under the worst case scenario (i.e., probability less than 5%), their portfolio would breakeven in 30 years. So except under catastrophic circumstances, the Smiths would meet their first goal of having enough money to live on for 30 years.
Also under the less conservative asset allocation, the Dynasty Trust would most likely be worth $16.4 million in 30 years, and no estate taxes would be due. Even under the worst case scenario, the Dynasty Trust would be worth $7.5 million in 30 years. That meets the Smiths’ legacy goal.
Let’s say that the Smiths make donations of $7,500 per year (growing 3.25% per year for inflation) from the Donor Advised Fund to their favorite charity. Even after this, the Donor Advised Fund portfolio is still expected to be worth $900,000. Again, under the worst case scenario, the Fund would still be worth $100,000. So adding the portfolio worth and the annual donations, the Donor Advised Fund would have been worth more than $1.1 million.
Adding it all up
So let’s tally things up. If the Smiths plow the proceeds of the sale into their very conservative portfolio, they’ll likely have $2.8 million in 30 years. Not so bad. But if they convert to a less (but still significantly) conservative asset allocation, and make gifts to a Dynasty Trust and a Donor Advised Fund, in 30 years they’ll have $4.8 million in their personal portfolio (worst case $0), $16.4 million in the Dynasty Trust (worst case $7.5 million), and $1.1 million remaining or already distributed by the Donor Advised Fund (worst case $300,000). So with proper planning, instead of converting their existing assets and business sale proceeds into a $2.8 million dollar estate, the Smiths would’ve created a $22.3 million dollar nest egg for themselves, their descendants, and their favorite charity. And even in the worst case, they would’ve met their cash flow needs for 30 years and still have $7.8 million as their legacy.
Yes, the sale price of the business is important, but what you do with the proceeds can make all the difference! Plan wisely!
Please note that this example is for illustrational purposes only and that the applicable scenario is different with each individual. This particular scenario was developed by J.P. Morgan. A Neumann & Associates is NOT a tax advisor or accounting service and merely relies on the advice of associated firms. Our firm can provide a Fair Market Value estimate for your business and then refer you to qualified tax advisors that can minimize the tax impact of a transaction.
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