April 11, 2019
Most of the private business owners we work with would probably say they’ve invested nearly “everything” into the success of their company: savings and income, lots of time, and of course, “blood, sweat and tears.”
The sacrifices you as a business owner make are laudable and often necessary, especially in the beginning. But as the company becomes profitable and your personal wealth in the business grows, it’s time to start diversifying your assets so your company isn’t your only investment.
The concept of diversification is familiar to business owners who know that successful businesses don’t focus on just one thing. They diversify revenue streams — via multiple product lines, different markets or service innovation — to sustain the business if customer interests or markets change.
Similarly, allocating some portion of your earnings to build a diversified, liquid portfolio will help you avoid unnecessary and possibly unaffordable risk and ensure your personal wealth is sustainable even through difficult business cycles. It can also help reduce your taxes and meet your family wealth-transfer or philanthropic goals.
There are several strategies you can use depending on the size of your wealth and goals for yourself and future generations — all while keeping your company at the center of focus. For the family business owners we work with, we start with the simplest solutions first. Often partial or combinations of strategies are effective.
Here are four commonly implemented options:
1. Gifting or selling business interests to family
In many instances, diversifying your ownership in your family business involves transferring or selling some or all of the company to the next generation. Many families have a goal of educating younger generations, not only about what it takes to run a successful business, but also around managing money, making good financial decisions and passing down family values.
A family limited partnership (FLP), a grantor-retained annuity trust (GRAT) and a defective grantor trust (DGT) are strategies that not only help business owners diversify their wealth, but also provide a forum to educate the next generation about managing money effectively. Discounts for lack of liquidity and lack of marketability are commonly applied to optimize the value of the gift and reduce estate taxes. If maintaining control of the asset is important, you might consider a sale to a DGT or an FLP. If you’d rather retain an income stream, a GRAT may be a useful tool.
2. Selling the business to your employees
An employee stock ownership plan (ESOP) can be an effective strategy to meet a business owner’s goal of diversification or succession planning while minimizing the adverse consequences for the company and its employees that often happen when a closely held business owner sells or leaves the company.
As attorney Brian L. Anderson, a partner at DeWitt LLP in Madison, Wisc., explains, “In the right situations, an ESOP can be a win for the business owner, who cashes in some or all of his or her company stock, sometimes at no tax cost; a win for employees, who pay nothing for the stock allocated to their ESOP accounts; and a loss for the IRS, which often gets no tax revenue until employees retire and cash in the stock in their ESOP accounts.”
3. Contributing to an employer-sponsored retirement plan
As a business owner, one of the easiest ways to diversify your wealth while saving for retirement is via an employer-sponsored retirement plan such as a 401(k). Contributions to these plans can typically be made pre-tax or on an after-tax (Roth) basis, allowing a business owner to save taxes either now or in the future and build a diversified portfolio to provide liquidity in retirement. The earlier you start saving, the more compound earnings will help your portfolio grow.
An employer-sponsored retirement plan also helps the next generation begin to build a diversified portfolio and can be an effective tool to attract and retain employees. You should consult your advisor to help you evaluate your options and recommend the right professionals to review the design and administration of your retirement plan.
If you want to give back to the community that has supported your business, you can incorporate philanthropy into your diversification strategy using outright gifts, donor advised funds and/or charitable trusts. Often these strategies can help you limit or avoid capital gains tax. Philanthropic tax planning around the transition of your business can make a big difference in the total tax liability, while helping to accomplish any charitable legacy planning that may be important to you and your family.
In all situations, long-range financial planning is key to giving you the confidence to proceed with diversification and wealth transfer strategies, knowing it won’t compromise your long-term financial security.
Start by having robust conversations with your wealth manager about your long-term goals for spending and gifting, such as buying a second home, paying for your grandchildren’s college tuition, traveling, etc. Your advisor should couple these goals with assumptions for investment portfolio returns and taxes, then stress-test the plan for different market environments and run multiple scenarios. In the end, you should come away with clear context and peace of mind that you have the financial security to execute your plan.
As you contemplate diversification and wealth planning strategies involving your family business, it’s critical your entire team of advisors is involved to ensure a win-win. Having your estate planning attorney, business attorney, accountant and wealth manager all sitting at the same table and working together toward accomplishing your goals allows you to rest assured that any strategy you execute has been thoroughly vetted from legal, tax and investment standpoints.
We’ve learned through experience that a business owner with confidence in their long-range financial plans makes thoughtful and informed financial decisions.
Having concentrated wealth in your illiquid business can expose you to unnecessary risk. Creating a well thought out long-term plan can improve overall results for the key stakeholders: you, your family and your business.
A wealth manager working with your other financial advisors can help you tie your diversification solutions to your overall business, family and philanthropic legacy strategies. This allows you to worry less and keep your focus on the success of your company and the rewards that come from it.
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