Developing an Exit Strategy

By: William J. Killory, CPA (Feb, 2011)

One of the habits from Steven Covey's book 7 Habits of Highly Effective People was to begin with the end in mind. In business and life this is sage advice. Often in our first meeting with a new client we ask about his or her exit strategy. In very broad terms this means accumulating enough wealth so that you can afford not to work if you so choose. This is done through traditional retirement vehicles such as 401(k) profit sharing plans or even the much rarer defined benefit programs. This is just one element of building wealth that goes along with building up assets through prudent investing.

For the business owner the most significant asset is typically the business itself. This is the economic engine that generates the ability to provide wages, benefits and investment return. There are three things that can happen to a business as part of an exit strategy, planned or otherwise. It can be sold, given away or go out of business.

In order to avoid the least desirable option of going out of business a lot of care, attention and planning go into the ongoing operation of a company to insure its future success. Exit planning goes beyond the day-to-day details; planning for the long term means developing strong internal controls, instituting solid business practices and building a strong balance sheet along with generating a healthy bottom line. Effective exit strategies can take years to develop and institute.

A prospective buyer of a business is more likely to buy the assets and ongoing goodwill of a company rather than buying stock. There are liability issues and tax issues that favor the asset purchase. Operating as an S-Corporation or LLC taxed as a partnership will reduce the impact of double taxation that the sale of assets within a corporation creates. Most C-Corporations can convert to S-Corporations but will be subject to corporate income tax on the built-in gains (excess of fair market value of all assets – including goodwill, less all liabilities) at the time of conversion. Typically it takes ten years from the time of conversion before the built-in gains tax is no longer applied. Currently this waiting period is five years but that will sunset after 2011.

The outright sale of a company to an unrelated party is the classic arms length agreement. Both parties negotiate the deal and agree on terms and consummate the deal. The use of a broker or investment banker can be useful in obtaining the best price. The transfer of a business to a related party is much more difficult. Sale or transfer of a partial interest brings up issues of control and value. Sale to a family member brings up issues such as are they ready for ownership and are you ready to retire and let the next generation take over? These can be difficult but unavoidable questions that need to be addressed so the business that you worked hard developing can survive beyond your working life. Sitting down with your trusted advisors would be a good first step in this process.

Related party sales or transfers can be challenged by the IRS as being part gift or compensation even if the transfer was done at fair market value. We recommend a qualified valuation be done anytime a related party transfer occurs in order to avoid this problem. With intra-family transfers we recommend filing a gift tax return with the valuation report so that the statute of limitations will run. With the return of the estate tax along with a much more generous $5 million gift and estate exemption makes this a good time to put plans into place for inter-generational transfers.

Well planned long term exit strategies contemplate orderly transitions. You should also make sure you have emergency exit plans prepared for the misfortunes life throws at us. Making sure you have adequate disability insurance to cover your inability to work and to provide for funding your replacement while you cannot work will soften the economic hardship that often comes with this type of disruption. Having adequate life insurance along with a plan of whom and how your business will operate will give your family and business associates direction and ease the financial uncertainty that these unexpected emergencies throw at them.

Planning for your retirement and transition out of the working world is a long term issue. We always think we have all the time in the world to accomplish this but time has a habit of flying by before you realize it. By beginning with the end in mind we force ourselves to focus on how we transition from the working world and how our business can survive and thrive for the generations to come. Sitting down with your advisors and developing a formal plan is a good first step.

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