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You Just Sold Your Business…What Should You Do with the Cash?

You Just Sold Your Business

Selling a business aǎer years of hard work triggers a flood of emotions for most business owners. The relief, joy, and excitement of seeing the proceeds hit their account is often mixed with anxiety as owners wonder what to do with their newfound cash. Those who deferred planning now face pressing questions, including:

  • Will the proceeds be enough to sustain my lifestyle?
  • How should I invest the proceeds?
  • The market is at an all-time high; is now a good time to invest?
  • Should I invest all at once or stage my entry over time?

While answering these questions may seem daunting, the key is to define what happiness looks like and how newly acquired wealth might help fulfill specific life goals.

Mapping the Long Term

To determine how best to deploy the net proceeds, start by quantifying core and surplus capital. Think of core capital as the amount an owner needs today to sustain her lifestyle with a high degree of confidence for the rest of her life. Surplus capital, on the other hand, represents extra wealth that can be used opportunistically to accomplish secondary goals like funding discretionary expenses, or gifts to family or charity.

Consider the Cashers, a 60-year-old couple who recently sold their business for $20 million. The couple wants to maintain their $400k per year in lifestyle spending while assuming only a moderate amount of risk. Using our proprietary Wealth Forecasting System, we quantified their core capital at $14.9 million and their surplus capital at $5.1 million. Notably, these figures assumed that all their capital was fully invested.

While the Cashers seemed comfortable with a moderate asset allocation when it came time to put money to work, they hesitated. Will a month or two delay materially affect longterm wealth building? Not likely. But languishing in cash over several years could. For instance, holding cash for five years while waiting to invest increased their core capital by 15.4%—from $14.9 to $17.2 million (Display).

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But the Market Is So High!

The Cashers felt torn. They wanted to avoid overfunding their core but also worried about buying in “at the top.” Yet when it comes to investing, there is never a perfect entry point. The market doesn’t send personal invitations—and if it did, some might reject them anyway. Consider the market conditions on March 23, 2020. In retrospect, it was the perfect moment to invest, though the “invest now” sign was obscured by the pandemic’s gloom.

Plus, even if you consistently invested at market highs, you could still generate attractive returns. Since WWII, an investor who bought at each bear market bottom earned 11.5% on average versus 9.6% for an investor who bought at each market top. And while it may feel uncomfortable to plow ahead at the peak, it’s not unusual. Since the market has historically trended higher, it has ended up trading near its all-time high roughly 43% of the time.

Take the Plunge or Wade Slowly Over Time?

Framing the historical context comforted the Cashers, though they remained reluctant to fully commit—a common sentiment among business owners. Successful entrepreneurs are usually innate risk-takers when it comes to their own ventures because they feel they’re in control. In contrast, markets seem irrational at times. Many business owners fear watching wealth they’ve spent decades building dissipate just because they’ve invested at an inopportune time. To combat this, some prefer to slowly dip their toes in the water by investing a little bit at a time—an approach called dollar-cost averaging (DCA).

Given that markets tend to driǎ higher over the long haul, DCA generally yields less wealth than going all in. Our analysis shows that the investor who dollar-cost averaged over six months into a global stock portfolio underperformed by 1.3% in typical markets and 7.5% in strong markets compared to investing immediately. Yet DCA can serve as a hedge in deteriorating scenarios. In weak markets, the investor who dollar-cost averaged was 5.0% better off. The Cashers acknowledged this cost-benefit trade-off, but still felt more comfortable pursuing a staged entry. Now they wondered how to proceed.

When implementing DCA, time proved the most critical factor. Beyond six months, the marginal benefit that a dollar-cost averaging strategy could provide in weak markets is outweighed by the cost in strong months (Display). For this reason, the Casher’s financial advisor recommended that the couple stage their entry over a three- to six-month period.

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Bucketing Your Cash to Achieve Your Goals

One common mistake that owners make is investing the proceeds as a single pot of money with a uniform focus and allocation. Instead, consider disaggregating your newfound wealth into different buckets with distinct allocations that match time horizons to specific goals (Display).

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Business owners who successfully exit often find that their windfall doesn’t come worry-free. Investing a large sum can feel nerve-racking. As you deploy your cash, explore the road map we’ve laid out. In addition to allocating across traditional stock and bond portfolios, consider alternative investments. Although “alts” are frequently illiquid in nature, in the right circumstances they may be an attractive diversifier, and they often have a capital call structure that simulates dollar-cost averaging into the portfolio. While cash can be a conundrum, your Bernstein financial advisor can help you navigate the key planning and investment decisions at each juncture along the way.

Authors: Andrew Bishop and Richard Weaver

Contributed by Troy Niehaus

Keep It in the Family: Family Bank

Bank

In working with the closely held family businesses, I have found the Family Bank to be an excellent tool when properly used. In his book Family Wealth, James E. Hughes says, “The Family Bank provides a means for a family’s wealth to be leveraged by making loans available to family members on terms not available commercially.” The Family Bank allows families to pass along substantial wealth through several generations, without encountering wealth transfer taxes.

How does the Family Bank work?

In essence, the business or wealthier, older generations loan funds to younger generations under preferable terms. These loans are at lower rates, have lower or no down payments, have longer repayment terms, are absent of loan fees, and contain fewer covenants and restrictions.

Loans can be personal in nature—for instance purchasing a home:

It is important to recognize this as an “enhancement loan” not a “reliance loan.” What I mean by this, is that any savings due to a rate that is lower than the market rate, or by the borrower not having to pay mortgage insurance, should be used to “enhance” the borrower’s financial situation. This can be done by allowing repayment of the loan over a 15- or 20-year period, rather than maintaining the same 30-year loan amortization. The latter may cause a “reliance” mentality: where the family member becomes increasingly reliant on the family wealth, rather than progressively less reliant over the course of time.

The IRS comes into play with related party loans and requires the interest rate to meet a standard called the “Applicable Federal Rate,” or AFR. During the month of July 2014, for a loan less than three years, that rate is 0.31%. For a loan term of three to nine years, the rate is 1.80%, and for loans longer than nine years, the rate is 3.02%. (Monthly Compounding. Rev-Rul 2014-20)

Loans can be for business opportunities—such as start-ups or acquisitions:

In the case of business opportunities, the borrower should prepare a business plan, discuss feasibility with the family leadership team, possibly provide security for the loan, document the understanding and terms, and eventually repay the loan.

What should the design of “Family Bank Loans” look like?

  • Available to all who meet specific qualifications
  • Promote financial stewardship
  • Possibly include guarantees by family members
  • Encourage family unity rather than “favorites”
  • Make financial sense

What are the practical aspects of designing the Family Bank Loan?

  • Draft a proposal for all parties to review.
  • Propose the amount of the loan and the key terms, amount to be borrowed, proposed interest rate, length of repayment, monthly payment amount (it takes us a few minutes to run an amortization schedule).
  • Outline the security. For example, record a trust deed for a home purchase loan to allow the borrower to deduct the interest payments.
  • Consider any potential landmines and address them up front.

Successful family businesses recognize that the family wealth is an asset to be well-managed. Additionally, opportunities to benefit the family members can also be excellent vehicles for passing on financial intelligence and stewardship.

Still curious to learn more about the Family Bank? Our team at Delap is happy to answer any questions regarding this tax concept, or any other accounting and finance challenges you may be facing. Reach out today!

Delap is one of Oregon’s largest local tax, audit, and consulting accounting firms, located in Lake Oswego.

Contributed by Dave DeLap

Family Gifting Plan

Gifting

In today’s high estate tax environment, it’s important to take advantage of as many of the tax savings opportunities that are out there. One of the best estate tax saving opportunities is to maximize the use of the annual gift tax exclusion. This means having parents or grandparents gift up to $15,000 (the annual exclusion in 2019) to as many family members as possible each year. Our recommendation is to make this a habit in January of each year. In large estates, each gift of $15,000 can save roughly $7,000 in estate taxes and even more in cases where gifts are to grandchildren, thereby avoiding the Generation Skipping Tax “GST.”

Although this can be an excellent tax savings, large families are often stymied by the different size and structure of each family unit. The grandparent often desires to treat each family unit equally, regardless of marital status of the child and the number of grandchildren. A carefully thought out plan should maximize the estate tax savings while working around the family structure issue.

Let me use an example of a grandparent gifting to children and grandchildren. We will use an example of four children. One child is married with four children, one is divorced with two children, one is single with no children, and one is deceased with one child.

The objectives should be:

  • Maximize as many annual gifting units as possible
  • Ensure each family unit receives the same gift
  • The grandparent makes all of these gifts to reduce the size of their large taxable estate

Step One is to determine the family with the greatest number of gifting units. So the married child with four children sets that base. A $15,000 gift to each of them would get $90,000 out of the estate and save the heirs roughly $45,000.

Step Two is to gift each of the other family units a total of $90,000 and maximize the number or available annual exclusions.

So, in the case of the divorced child with two children, the grandparent gives $15,000 to each of the two grandchildren and $60,000 to the child. Since we have three recipients of gifts, we have excluded $45,000 from estate taxes and saved $22,000 for the heirs.

In the case of the single child, the parent makes a gift of $90,000 and we are able to exclude $15,000 and save $7,000 for the heirs.

In the case of the deceased child, a gift of $90,000 is made to the grandchild and we are able to exclude $15,000 and save another $7,000.

Overall, we have met all of our objectives by keeping the family units equal in the total amount that they receive. In this example we have gifted $360,000 out of the grandparent’s estate and saved $81,000 in estate taxes. For Oregon residents the gifts would not be added back to the estate at death and there would be an additional tax savings of roughly another $30,000 for a total savings of over $110,000. It should be noted, that gifts to individuals above the $15,000 annual exclusion amount are considered “taxable gifts” and will reduce the lifetime exclusion amount of $11,400,000 available to each taxpayer.

Every family is different, so give us a call and we can develop a gifting plan for your particular circumstances.

Contributed by Dave DeLap

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