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Mind Your Business: #2 Why Selling Your Business May Be a Massive Pay Cut

| October 06, 2017
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If you have ever thought about selling your business and walking away with a big pay day, I urge you to consider what the financial ramifications on your lifestyle would be.

*I will not address the specific tax consequences here; I am more discussing taxes in a general way. Obviously, your own tax situation would change these outcomes a bit.

Please also know that I am not trying to address, nor can I properly address, the emotional, psychological, family or personal reasons that you would or wouldn’t want to sell a business. I simply want to shed a bright light on the financial implications on your cashflow.

Let’s first consider the “owner’s benefit” that you are receiving from your business. “Owner’s benefit” is not just salary; nor is it salary plus distributions, bonuses or other cash compensation. An “owner’s benefit” would need to include any spouse or child income from the business and might also include other living expenses the business pays for such as: vehicles, cell phones, subscriptions, donations, golf, entertainment, dinners, lunches and a plethora of additional items that you would like to continue to do or fund or purchase whether you own the business or not. “Owners benefit” therefore is the grand total of these items plus all the cash compensation.

In order to keep the example simple, let’s assume the value of your business is $10M and that your “owner’s benefit” is about 10% of the value of the business or $1M per year. If you think about it, that is the equivalent to a 10% “dividend” from the business. If this business sells for the $10M, let’s also assume that the owner will walk away with roughly $7.5M (in the state of Georgia). This is where most entrepreneurs stop the analysis because after all, “Who can’t live on $7.5M?” they ask. While no one would say $7.5M isn’t a lot of money, most people, including myself, have a hard time defining what $7.5M means to us. It is hard for us to relate to a large sum of money like this. That said, we can relate to an income stream and in this case, the income stream we could safely withdraw is about $300Kper year, which is a far cry from the income plus benefits of $1M you were previously receiving.

Regarding the $300K income, please know I am not addressing the rate of return that the business owner would receive on those investments. I am only addressing what a safe withdrawal rate would be. A safe withdrawal rate is defined as that amount of income that can be withdrawn from a portfolio of well-balanced stocks and bonds that would allow inflation adjustments and would pay that income for the life of the business owner and his/her spouse.

The first study on safe withdrawal rates that I recall was the one done at Trinity University in 1998. This study and many others, subsequent to this one, have stated that a “safe withdrawal rate” is in the neighborhood of 4%. More recent studies have suggested that this safe withdrawal rate might be closer to 3 to 3.5%. In addition, the safe withdrawal rate is going to be impacted by the age of the business owner, in that it must be a lower withdrawal rate at 50 years old, but it can be higher if you sell at age 70.

Doing the math, $7.5M at a 4% withdrawal rate would generate $300K per year of taxable income. The difference is that the $1M of “owner’s benefit”/income relative to the $300K is an enormous pay cut. If we look at the income/“owners benefit” before the sale and afterwards, the business owner must go from $1M of income (some of which is tax beneficial) to only $300K of income.

In summary, the next time you dream of selling your business, please remember that there’s a good chance that doing so will result in an enormous pay cut to the owner and their family.

Up next, we’ll get into #3 of the 10 Most Common Business Owner Blind Spots series – Saving and Investing the Right Amount. Stay tuned!

 

References:
Bengen, William P. (October 1994). "Determining Withdrawal Rates Using Historical Data" (PDF). Journal of Financial Planning: 14–24.

 

 

Guardian, its subsidiaries, agents, and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation & hypothetical examples are not intended to suggest a particular course of action or represent the performance of any particular financial product or security.

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