Are There Skeletons In Your Closet
Posted on October 12, 2012 by Colin Funk
I recently came across an article written by Heidi Bolger, CPA/ABV that was published in the AICPA CPA Insider September 17, 2012 that discusses actions business owners should take PRIOR to beginning an exit process. These constructive ideas should be part of any exit strategy and done well in advance of a business sale. The B2B CFO® GamePlan™ process covers these very activites…and the starting point is a complimnetary Discovery Analysis™. I am proud to serve the Modesto, Stockton, Fresno and greater central valley region as a Partner in B2B CFO®
Excess cash and investments. Some of the most conservative owners use their business accounts to accumulate more cash and investments than the business needs for operations. Rather than having to explain an “excess working capital” add-back at the time of exit, it’s advisable to have the owners extract this excess capital and get a favorable dividends tax rate on the proceeds.
Receivables and payables to owners. These amounts tend to accumulate over time and, in some cases, nobody even remembers how they came to be. Netting out these amounts and either getting them settled through a payoff (including an amount in the owner’s W-2), converting debt to a capital contribution or formalizing an installment note are all good measures to clean up the balance sheet and avoid a discussion later about the whys and hows.
Intercompany debt. It’s not uncommon for related business entities to provide or receive financing from each other. This practice creates an interweaving of business finances with terms that may be above or below market rates or nonexistent. If you plan to sell less than the entire family of businesses, it’s a good idea to get external financing in place or at least get the terms on any debt in line with market standards.
Property and equipment. As time passes, owners can acquire a variety of assets in their businesses that may be nonessential to operations, and yet have significant value (such as artwork, boats, planes, real estate held for extended periods of time, in prime locations or with mineral rights, etc.) as well as assets with sentimental value. Extracting these assets from the business in a tax-favored way and avoiding the accumulation of more nonessential assets should be a key goal in preparing the enterprise for sale. Often, this requires identifying which assets are in the business, since the depreciation schedule doesn’t always include everything owned by the business and the titles can be incorrect (for example, what should be in the name of the business is titled as personal property and vice versa).
Life insurance policies. An entire book could be written on how life insurance should be structured (e.g., through the business, using a life insurance trust, or held personally by the owner(s)); who should own the policies at different phases of the exit process; and the best way to access value if the business cancels a policy. This can be quite complicated and take time, so a review well in advance of an exit will be time well spent.
Accumulated earnings and profit. Tracking accumulated earnings and profit (the amount of previously taxed income retained within the business) is essential to determining the tax consequences of distributions from the business that often go along with a transfer of ownership. It’s important to be clear on what this amount is and to do some advance planning. If we can find a way to extract excess cash on a tax-free basis it will no doubt be music to owners ears.
Below market rental arrangements. Many times the amount of rent being paid to a separate entity also owned by the majority owner(s) of a business is merely sufficient to cover the debt service on the real estate. Resetting the rent to a level that represents fair market value will enhance the current cash flow of the owner (or if the business is cash strapped, at least create a future obligation for back rent). It will also avoid having to negotiate a big rent adjustment when the business changes hands in cases where the real estate is not part of the sale but will continue to be occupied by the business.
Contractual agreements. In the dealership or franchise world, clients often face a formal approval process for any ownership changes. In other situations, the bank, bonding company, key customer, or supplier relationships that are essential to the business’s success may need to be carefully managed and negotiated to ensure the planned exit doesn’t create problems. Reviewing these agreements and relationships in advance will help identify any proactive steps that need to be taken (including renewal) to ensure a smooth transition.
Compensation and perquisites. As advisers, we understand the wide discretion that closely held businesses have in the compensation and perquisites paid to owners. If the owner(s) intend to stay on for some period of time after the sale, their compensation package prior to the sale could have some relevance. For instance, if the transition of ownership is to key employees or family members, it may make sense to adjust the package to the “right number” well in advance of the exit. This will create a good starting point for a “proposed” phase down compensation package during the years the owner’s involvement is phasing out. It’s hard to make this part of the negotiation go away completely, but having some historical precedent/practice can help the exiting owner maintain a fairer level of compensation for longer.