Historic low interest rates during the past several years have not only been a catalyst for economic growth, they've also created enormous demand by private equity firms seeking to invest in a wide range of small businesses. In turn, these investments have created a "once-in-a-generation" opportunity for thousands of small- and medium-sized businesses, raising their value and minting new millionaires across our nation.
Data from BizBuySell Insight Reports shows that a record number of small businesses were sold in the third quarter of 2017. A total of 2,589 transactions were reported nationwide, a 24 percent increase from this time last year. This puts the number of sales so far this year at 7,491, making it a record-breaking year for small-business transactions. Just as important, the median sales price is also up year-over-year, by about 15.7 percent.
According to Thompson Reuters, private equity funds raised more than $340 billion in 2016. And with a 12 percent increase in the number of private equity funds this year, 2017 expectations are similarly high. In recent years, I've worked with several business owners, whose companies were valued from $1 million to $100 million.
But with the Federal Reserve set to meet and raise interest rates on December 12–13 — and possibly throughout 2018 — the window to take advantage of the economics of these deals may be starting to close. Borrowing costs will rise, making it more difficult for private equity firms to profit from future acquisitions.
To take advantage of this window, the entrepreneurs that created these businesses need to determine soon if they want to cash out. As a financial advisor who works with many entrepreneurs, here are a few items to help business owners maximize their potential profit and tax benefits.
Determine the right business structure
The correct business structure can make a significant difference in the net proceeds from a sale. I've found that a surprising number of older small businesses are structured as "C" corporations, which means sale proceeds may be taxed twice, at the company level and again as shareholder dividends.
For sole owners of a service-based business, an S Corporation may be a better choice. As a so-called "pass-through" entity, it would escape any corporate level taxes. These businesses also generally have few depreciable assets, so most of the proceeds receive capital gains treatment to the owner. But beware, if your S Corporation owns real estate that you are not planning to sell because you want to keep the rental income, you will likely pay additional taxes.
For businesses with multiple owners or that require a large asset base, such as real estate, a Limited Liability Company — another type of pass-through entity often structured as a partnership — is a flexible and inexpensive option. However, if you have any significant charitable intentions for your sale proceeds, this structure can create unintended additional taxes. Most often, this is in the form of unrelated business income tax. This is a tax imposed on the charity that reduces the value of the business owner's gift. With planning, these additional taxes can be avoided, so early communication with a tax advisor is key.
Understand how a sale creates financial independence
The thought of losing control and a familiar source of income can be terrifying for many business owners. So it's critical to know how much money you need to net from a sale.
Take time to calculate your annual living expenses before the sale and be sure to include a buffer for larger one-off expenses like a new car or home renovations. After that, determine other income sources, such as pensions, rental income or even Social Security that you'll have after you sell your business. The sales proceeds will need to cover the difference between annual expenses and other cash flow sources.
I've found that many business owners are so busy running their companies that they don't realize they have significantly more assets than they need to be financially independent. "Knowing your number," can help ensure you take advantage of the right sale opportunity.
Make legacy planning part of the equation.
A surprising number of business owners I consult with don't have an adequate will and haven't even considered how their business should be incorporated into this planning. With proper planning, they could leave a much larger portion of their wealth to their children, or even grandchildren, and much less to the government.
The US Congress' tax reform plan may raise the estate tax exemption amount, or even eliminate this tax altogether. But keep in mind changes can occur every few years. Given this, legacy planning will continue to be an important consideration for business owners.
Donate some proceeds to charity
Many business owners contemplating a sale also want to kick start their philanthropic goals. Developing a plan for charitable giving can save millions in taxes and provide additional purpose to the next phase of their lives. But it's tricky; the way a sale is structured can save money for some owners, but not others.
I recently worked with one business owner to make certain his sale met these goals. By choosing to make a charitable gift from a portion of the business before selling it, the owner eliminated the taxes that would have been realized on the sale and received a full tax deduction for the gift. The result: the business owner's tax bill was reduced by over 70 cents for every dollar donated to a nonprofit.
Too often, individuals focus more on getting the buyer to pay the maximum price rather than maximizing how much of that price they actually get to keep. This distinction makes all the difference to a business owner transitioning to the next phase of their life.
While the current economic environment is favorable to achieving a premium sales price, time may be running out. Business owners considering a sale should review their objectives now and determine if a sale makes sense in the near future.