WEBVTT
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In the world of business.
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Not all deals are what they seem.
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Fortunes rise, empires crumble, all with the stroke of a pen Mergers, acquisitions, hostile takeovers.
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Welcome to Mergers, she Wrote, where we examine strategies and stories behind the biggest deals in business, because in M&A, the real risks are the ones you don't take.
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Welcome to episode three of Merger, she Wrote.
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I'm here today with my guest and close friend, susie Erick.
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She is a senior relationship strategist at PNC Private Bank, specializing in working with business owners to help them understand and manage the complexities of wealth and tax finances.
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She also holds a master's of taxation and is a certified financial planner and certified exit planning advisor.
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Today, we're going to be talking about why it's critical for business owners to create a plan well in advance of exiting or passing on their business to the next generation.
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We are also going to be talking about charitable giving in your business and in your personal life, and why it can be important for tax advantage purposes.
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And, finally, we are going to emphasize the importance of a clean and orderly balance sheet.
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Thank you so much for being on today.
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Yeah, thank you, I'm really excited to be here.
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Likewise, so you know, you and I both work a lot with clients that have.
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You know their family owned and operated businesses they're looking to start.
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You know the succession planning or the exit planning phase of their business.
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You know from just at the stop.
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You know at the start when should a business owner start thinking about an exit strategy and what are the key first steps.
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It's a really good question and everyone asks and you can probably Google this as well and you will get a myriad of different results.
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But there's two answers.
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I have to that the first.
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And when you think about exit planning to just backing up a lot of, a lot of folks will think about, oh, that's retirement planning, and a lot of business owners don't think about retirement but exit planning in general.
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For for us as practitioners, we're always thinking about any type of exit is that can be retirement, that can be somebody passing away, it could be a disability, it could be just pulling back for a period of time.
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So just putting some context around that.
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But as an owner, we say two things.
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Either one start with the exit in mind.
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So when an owner is starting a business, they should be considering what happens if I can't run this business anymore.
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Ideally, what would I do with this business?
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Now, many of the business owners listening to this might already be well into the business, so we can't go back.
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So ideally, three to five years prior to an exit.
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The reason that we say three to five years and you'll see this in many places there's kind of three key themes why and you'll hear me use three a lot, kind of three key themes, why and you'll hear me use three a lot um, so the first is one timeline.
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So we all have an ideal timeline for what we want to accomplish, but a lot of times there's a lot of things out of our control.
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So if we can plan three to five years ahead of when, ultimately we might want to exit, that timeline might change, but at least we're already thinking about what we're trying to do.
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Are we going to sell to a third party?
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Do we want to bring the family in and start transitioning them in?
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Are there some planning?
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Is there some planning that we want to do?
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So I say three to five years.
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So some of that's the timeline, the why.
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The other piece is planning.
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So if we have enough time before we want to exit, then we can do a lot of different things.
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And so what I mean by that is practitioners we have.
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We have a big toolbox of things that we like to play with to help owners plan for their exit.
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And in order to use those tools in the toolbox, we need time, and we'll talk about some of those tools a little bit later.
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But we need.
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We need time and we'll talk about some of those tools a little bit later, but we need some leg room there.
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I like the idea that you shared about starting with exit in mind, because it is so unfathomable to so many young or small businesses that at some point they're going to be big enough or successful enough to exit and by the time you've come to that realization, like you said, they're well into the life cycle of their business and they haven't done any of the pre-planning.
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And so that's often a conversation I even have with my clients where I'm like you're a startup now, but you know what does happen if you suddenly become incapacitated and you can't do anything to get your business to continue to run.
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I actually had a really sad story a year and a half ago come to me where the person didn't have an operating agreement, had a heart attack and there was nothing written down to allow the daughter to step in and wind up the business, which I think highlights what you just said.
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Right, I mean, it's so difficult to have this mindset of.
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It's almost like estate planning for your business.
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Yes, that's exactly what it is, and we say that all the time too.
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I'm glad you use it too.
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So three to five years.
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I totally agree with you there.
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You know we were talking about how we're going to say more about the toolboxes.
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I think this is a great segue.
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Why don't we just start talking about the toolbox?
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Absolutely so.
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When we're thinking about exit planning in general, a lot of folks will come to us and say, well, how do I save taxes?
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Or how do I do this transition in a way that's effective, efficient, where it's not going to change my business and what we're doing?
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So the toolbox for us there's a few pieces.
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Um one, I'll go to the tax planning when I think that's my area of expertise.
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But also, every business owner always loves to talk about taxes and how not to pay them.
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Um, but so for tax planning purposes, if an owner wants to minimize some of the income taxes maybe, or estate taxes, because they've built a really successful business and the value of that business is something that, from an estate tax perspective, if they passed away the IRS is going to be a somewhat beneficiary of that estate before their kids are.
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So some of the planning that we can do one is gifting over time.
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So if this is from an estate tax perspective, this is a family legacy business.
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If we want to start shifting that to family members, it's very efficient to start doing that well in advance of any type of potentially sale liquidity event.
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Doing that year over year has incredible benefit where we're using trust structures and things like that to do that.
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The other piece of that is giving us time to let some of those transactions we call season so just like when we're seasoning recipes, the IRS does not love it and, you'd be surprised, does not love it.
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If we do something, if we maybe transition to kids right before the sale of the business or we do some other tax planning right before we have a liquidity event, the IRS is going to say you did that for tax planning purposes, didn't you?
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And we try to say no, no, this was purely because we wanted to transition to the family.
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So we need time between doing estate planning and tax planning and before a transaction of a business.
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So those are some of the tools in the toolbox, which is why again kind of going back to the timeline is we want some time to do those.
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That makes sense.
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So, going back to what you were saying, where you're doing sort of gifting, but gifting at, you know, incremental doses.
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Yes, just for clarity for the listeners, you're talking about gifting of the equity in the business, right?
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Yes, for clarity for the listeners, you're talking about gifting of the equity in the business, right.
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And so, for those people who maybe aren't quite super savvy with how the equity would change hands, maybe you could describe to us a little bit like for just give a good example of like, how does that look?
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You know, does the ownership change?
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You know, how does the operation of the business change?
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Just kind of give a broad bird's eye overview of what that looks like in reality?
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That's a really good question and thanks for leading me down that path to clarify.
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So I'll give you an example.
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There's a family that we're working with very successful business it's.
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They're still in growth mode, so there's still a lot of runway to grow.
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Owners are early fifties, so they have kids that are in their twenties.
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Ultimately they want this business to be a family legacy business.
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The value of it is is pretty substantial.
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So the value right now is we'll just put a round number around around 50 million.
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So what they're doing with that business is, over time they're they're they've been gifting one percent of the business into a trust where the kids are a beneficiary of that trust.
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Practically what that means is they're going to their attorney, they're drafting up they drafted up the trust document and they're changing in the operating agreement.
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They're making some changes there In terms of operation of the business.
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Nothing changes.
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So the kids aren't coming in and all of a sudden they're sitting at the boardroom table saying I don't approve, so nothing is changing there.
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But the benefit is that now we've slowly started to move some of the interest into trust for these kids, that over time that value is going to grow in those trusts versus value growing in the owner's hands where that could potentially be in a state tax situation.
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So that's practically how that looks.
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I love that answer.
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You knocked it out of the park because I was hoping you went down that road.
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One of the misconceptions that I come across in my practice is that when we start implementing right, the business law and estate planning law are sometimes on two tracks that are parallel, but they don't seem to communicate well together.
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Just not all the time, but sometimes.
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And so I had recently, you know, had this conversation with, similar to what you're talking about, business owners.
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You know husband and wife crushing it.
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You know super successful business and their estate planning attorney had created a trust and the intention was to move all the ownership into those trusts.
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But there was a disconnect on the back end, which you referenced, about changing the operating agreement.
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You know, for us in business law, you'd want to also change the Arizona Corporation Commission or your Secretary of State, depending on where your entity is filed, but to essentially change ownership so that the equity, the baseline equity, is held by the trust.
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And this panic button was hit in this conversation that I recently had, where they said well, Paloma, we don't want the trust to be making all these decisions.
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And I told them no, reassured them.
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That's not how this works, right, the trust is ultimately the quote unquote owner at the backend, but the managers, the officers, the people who are in charge of day-to-day operations remain.
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You as individuals.
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That's right and that and that's really the goal Now, ultimately over time, when we're thinking about family transition, which I know we'll probably get to at some point if that's ultimately what they want for their family.
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So, going back to the example I was telling you, where the owners are still early 50s, they're still in the middle of the grind and they want to be.
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This is what they love doing.
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Fast forward 10 years from now, if they're now approaching the time where they want to exit, now maybe they start gifting more, or now maybe that percentage of interest has now shifted more to maybe 51% to the kids and now parents are 49% and that balance of power maybe does shift.
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But when you're talking about family, you want to potentially do that over time to give also the kids just a little bit more understanding of the business, helping them understand and grow with the business.
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So ultimately that power can shift.
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But the owners of that business have full control over when they want to do that.
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They can pull that trigger.
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Excellent point about the transfer of equity over time, also giving that buffer of allowing the kids especially if the kids are on the younger side to transition into the business from a, you know, officer or director position in a way that they're not just thrown into the deep end and asked to tread water.
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That's right.
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So I like that idea of also you're becoming sort of ingrained in the business little by little, year over year.
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Have you ever seen instances where the family is doing it all right on paper but then the actual transition in real life isn't happening in the same cadence as the transition of ownership is happening on paper?
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Yes, that's a really good question.
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I vividly remember a family.
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So we did a family meeting, which I highly recommend for any family businesses and I promise to the viewers this won't be all about family business, but we'll stay.
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Recommend for any family businesses and I promise to the viewers this won't be all about family business, but we'll stay here for just a moment.
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Having a family meeting where you have the owners and their kids in one place outside of the boardroom and with a state planning attorney, a financial planner, cpa, either all three or one of those folks kind of leading the discussion, I think is is should happen all the time.
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So this brings me to the point.
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We had a family meeting.
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We sat on paper, everything was being done right, but they had not had conversations, and I think that's where the the most challenging pieces is.
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They had not had family conversations about what ultimately the goal of this business is.
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And the kids?
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There were three kids and there was mom and dad, who were owners of the business, completely different ideas on where they wanted the business to go.
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There was no employment agreements with the kids that was the one thing that was missing and no direct path for the kids to start taking over management, which is a key point.
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That, to the earlier comment you made can't just hand over the keys and expect that just because even they've been working in the business that they're fully ready to be an owner.
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For any owner listening they know that is a completely different beast, and that was one of the most interesting and eye-opening conversations for me, sitting there watching two sides of the family argue because they did not see where this was going, and so it was clearly a missed opportunity for communication and I don't know where that ended up landing, but it was.
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They needed to just have more of those conversations, so I think I think it's important to highlight too, that family meeting, as much as we're talking about family owned and operated businesses, can be just as applicable in businesses where individuals are longtime friends or longtime business partners, have known each other for so many years that they might as well be quote unquote family, where this idea of sitting down and talking about what the future will look like from an ownership standpoint is not solely something that is exclusive to family owned and operated businesses.
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You should consider having a family meeting with your people who you're really close with, and especially if you're in the middle of your business's life cycle where you're starting to look ahead and maybe you haven't had those tough conversations.
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And and I think one of the other challenges is, how do you start having those conversations without freaking everybody out and causing panic?
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And I like that you had highlighted about this family meeting that you participated in was that the kids didn't have employment agreements, and it's so funny because in a lot of instances with my clients I try and emphasize that I don't care if you're going into business with your sister.
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I know you love your sister and she's family, she's blood, but you and your sister could have a massive falling out and so the operating agreement needs to be put in place, even though it's a financial undertaking.
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There's a lot of really deep dive discussions about, you know, the things that nobody wants to talk about, like divorce, death or disability and people will shy away from it.
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Because, like divorce, death or disability, and people will shy away from it because they're like, ah, it's my sister.
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Or, fill in the blank with whatever that person's title is, it's my husband, it's my brother, it's my cousin, it's my best friend from high school.
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I've heard that one a million times over and I always say like the operating agreement is like your prenup for your business, right, and without it you don't have the formalities, because what happens if you are in a disagreement?
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So to your point lack of employment agreements, a point of contention, potentially because there's nothing to govern the relationship that those kids have with the business on a formal basis.
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Right, and if mom and dad passed away, if they were in a car accident and couldn't make decisions for six months?
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Now all three kids are in the business.
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One is the marketing.
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I clearly remember this.
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One was marketing, one was in charge of sales and then another, um, was involved more on kind of the day-to-day.
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Which one is going to start making ownership decisions, um, without without something in writing and also without having clarity just in conversation alone, what mom and dad wanted?
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So to that point, just having everything in writing.
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I mean we do that before we get into a marriage we have these conversations.
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But a business is just as much of a marriage as it is in relationships.
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So I think there's a lot to be missed there, but a lot of conversations that should be had.
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Agreed, agreed.
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Well, I know we've been talking a lot about family owned and operated businesses, so let's let's switch gears here a little I want to talk to you about.
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You know tax is your specialty.
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You know how can someone maximize their tax position from either before, during or after.
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Pick, pick and choose or cover all three, I don't care.
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But I'd like to know your thoughts on optimization for any business owner who's thinking, planning or currently exiting their business.
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Yeah, so I'll put all of these together because a lot of the planning can be done before, during and after an exit.
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There's a few things to consider kind of leading up to an exit, and that certainly is when we're thinking about if we're going to the three to five years.
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Having a conversation, first of all, with a CPA and financial planner together is critical.
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So I would say anyone listening to this is have that conversation and bring those two parties together.
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So we're thinking about strategically how is the business set up?
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One is it set up the right way?
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So my first tip is is it the right structure?
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Or, if it's a C corporation or an S corporation or any type of partnership, whatever that case may be, is that the right structure ultimately for the business?
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And if we're thinking about, let's say, this is a third party sale of the business that ultimately we want to have, is this the right structure?
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Because it ultimately affects the income taxes and income taxes along the way prior to sale.
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So that is number one.
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I would say have that conversation.
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Two, kind of thinking about the sale.
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So, as we're leading up to and this is your world, so I'm not going to take your, I'm not going to steal your- thunder, but I'm going to maybe throw you the ball a little bit.
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Contract negotiations in an asset sale in particular, that number one I would say in a transaction is probably the most impactful way to is probably the most impactful way to the most impact on income taxes on the sale.
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Because, ultimately, if somebody is offering a price and that price is allocated to items that are capital gains and if we all remember capital gains are taxed at 15% or 20% or if some of that price and that check that you get in your hand was actually allocated to ordinary income, which is 37% income tax, there's a huge difference between 37% and 20% and the way that that's allocated in your world contract negotiations.
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So there's some magic and you could probably talk a lot about that and how that's done.
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But there that's a critical point in income tax planning that I think a lot of owners don't realize.
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Um, and should be leading on, should be leading on you there.
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Excellent points.
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For anyone listening who doesn't fully understand capital gains, could you just give us the lay person's really simplified what is capital?
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gains?
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Yes, so there are.
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In the income tax world there are kind of two types of income taxes.
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One is ordinary income tax, which is it's a any of your income, so think your W-2, salary, interest and dividends.
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If they're not qualified, those items, they're all taxed at ordinary income rates which range from zero up to 37%, and that top range is north of 600,000 of income.
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So usually it takes the highest level of income to get there.
00:21:40.307 --> 00:21:56.195
All other sources of income, so anything that's capital gains, so qualified dividends If you're selling property, so selling a business, generally speaking, that's usually capital gains.
00:21:56.596 --> 00:22:04.420
I talked about dividends as well, so those are preferential tax rates and that ranges from zero to 20%.
00:22:04.640 --> 00:22:06.586
So all of our income.
00:22:06.586 --> 00:22:10.865
I always like to think about it this way and I'm going to get a little bit nerdy here for a second.
00:22:10.865 --> 00:22:20.750
But any income that you get, it's put into a big bucket and sorry I'm using my hands on this podcast, but it's put into a big bucket and we pour all of our ordinary income in that bucket.
00:22:20.750 --> 00:22:32.540
First, we pour all of our salary in there, we pour all other sources of ordinary income, all that interest you're getting on your cash in the bank, things like that we pour that all in and then we pour in capital gains on top of that.
00:22:32.540 --> 00:22:57.972
So if we can try to have most of that bucket filled with capital gains, it's going to be much less income tax burden than if more of that bucket was filled with things that are ordinary income and in a business sale ordinary income looks like inventory or accounts receivable or some other things that get a little bit in the nitty gritty, which probably for another podcast, but it really it can have a big impact.
00:22:58.560 --> 00:22:59.723
Okay, I love the analogy.
00:22:59.723 --> 00:23:01.307
I'm huge on analogies.
00:23:01.307 --> 00:23:06.647
I think they're great for helping people, especially spatially brain people, conceptualize complex topics.
00:23:06.647 --> 00:23:12.128
Two, I love that, just to highlight that Susie just knows what she's talking about.
00:23:12.128 --> 00:23:16.547
I did not prep her for the capital gains question, so I appreciate you doing that on the fly.
00:23:16.547 --> 00:23:25.240
I think that's an excellent way to put it and I think it will help anyone who's listening to better understand kind of the difference between the two.
00:23:25.320 --> 00:23:29.949
On a general basis, I want to rewind just a second to talk about.
00:23:29.949 --> 00:24:04.265
You had mentioned in passing people having, you know, deciding what the right tax status is for the company, and I, over and over again, I get questions about, or people who just have a misconception about, what a tax status for their company means, and so I wanted to clarify that when you have an LLC and you do an S-corp election, the S-corp election is only at the state, or sorry, at the tax level, and at the state level you remain an LLC.
00:24:04.265 --> 00:24:09.724
And so a lot of times I you know we'll start working with someone and I'll say, oh, what form of entity do you have?
00:24:09.724 --> 00:24:10.346
And they're like an S?
00:24:10.346 --> 00:24:22.442
Corp, and I'm like, is that a, a corporation with an S corp or an LLC with an S corp, and they're like it's just an S corp and I'm like no, no, no no, I just had this conversation this weekend with uh.
00:24:22.482 --> 00:24:29.405
They were a new business that were getting started and they were trying to get their tax ID number and the question was what are we?
00:24:29.405 --> 00:24:32.207
And they said they were an LLC.
00:24:32.207 --> 00:24:33.327
And then we move forward.
00:24:33.327 --> 00:24:35.509
And then I said, well, wait a minute, are we a partnership?
00:24:35.509 --> 00:24:36.529
Are we an S corporation?
00:24:36.529 --> 00:24:38.009
And it was just very confusing.
00:24:38.009 --> 00:24:43.212
And it's literally what you tell the IRS you are is, I'm an S corporation.
00:24:43.212 --> 00:24:49.476
The LLC does not compute with the IRS, or I should rewind the IRS does not recognize LLCs.
00:24:49.476 --> 00:24:54.357
They recognize S corporation, they recognize partnership, they recognize corporation.
00:24:54.357 --> 00:25:07.088
They have no idea what an LLC is, to put it in that way, the state, on the other hand, and from a legal perspective, that's where the LLC or a true S corporation comes in.
00:25:07.953 --> 00:25:21.913
I am so glad you mentioned that because it's important to also note, related to that topic, that when you are an LLC and you do an S-corp election, it does change what you can and cannot do in your operating agreement.
00:25:21.913 --> 00:25:23.182
So that's something to consider.
00:25:23.182 --> 00:25:37.869
If you are an LLC and you have, since formation, done an S-Corp election, it's time to revisit the operating agreement, and if you don't have one, it's really time to revisit the operating agreement.
00:25:38.852 --> 00:25:39.333
Yesterday.
00:25:39.333 --> 00:25:42.067
Yes, so okay, this is great.
00:25:42.067 --> 00:25:49.212
What are you know kind of moving down this list of questions I have for you and I'm sorry we have so much to talk about.
00:25:49.212 --> 00:25:53.051
I'm just enjoying this so much.
00:25:53.051 --> 00:25:59.932
So what are the best ways for business owners to transition from income-driven mindset to managing personal wealth?
00:25:59.932 --> 00:26:12.730
And I think you and I have had this conversation separately, but it's so easy for someone to you know they're operating this successful business, they're really entrenched in this mindset of growth.
00:26:12.730 --> 00:26:24.890
You know, driving revenue, building the business bigger which unfortunately, I feel like is a resounding theme nowadays is just to build bigger without necessarily first building better.
00:26:24.890 --> 00:26:44.209
But that plays really into your world as well, because a lot of people think, okay, wealth strategies and tax planning are this bubble over here, and my business and the growth of it and everything else is over here, and there might be some weird interplay in the middle, but they don't think of them as being interrelated.
00:26:44.209 --> 00:26:46.246
So talk more about that.
00:26:46.539 --> 00:27:16.030
Yes, this is probably the biggest piece where I see the biggest missing piece in a business owner's plan in general is not having a personal financial plan and kind of going to that point of not really thinking about the personal financial side, because everything is wrapped up in the business and my husband's a business owner for the last 20 years and I fully recognize that a lot of expenses are run through the business and you know you're using your card a lot for legitimate reasons, don't get me wrong.
00:27:16.030 --> 00:27:17.482
So this isn't recorded with the IRS, right.
00:27:17.482 --> 00:27:29.709
But you know, like everything is run through the business, the cash many times stays in the business because it's being used for working capital or you know they just want to keep it in the business for the growth mindset.
00:27:29.709 --> 00:27:35.345
So everything is all of the wealth and everything is tied into this business.
00:27:35.345 --> 00:27:36.748
That is a piece of them.
00:27:37.710 --> 00:27:43.567
Where I think there's a missing piece is looking at the personal financial side.
00:27:43.567 --> 00:27:46.527
Considering that, just like your business, you have a balance sheet for your personal side, you have a P&L.
00:27:46.527 --> 00:27:52.601
Considering that, just like your business, you have a balance sheet for your personal side, you have a P&L and that should be operated the same way that you do in your business.
