Exit strategies Featured

7:00pm EDT January 31, 2007

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 CPon@VLSLLP.com.