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Why Using Deferred Comp is Crucial in Selling your Business

If you plan to transfer your business to your children or your managers deferred comp is an absolutely crucial component to add safety to your transaction.  The problem in many internal transactions is the tax cost of buying the business is often so high that it becomes unaffordable for insiders to buyout the senior generation; even if the senior generation is willing to hold paper.

When I talk about tax cost I mean the amount of money that must be earned before principal can be paid.  For example, if you are in the 40% tax bracket you will have to earn $1,800,000 – pay $800,000 in taxes to be left with the $1,000,000 to pay someone for their stock.

If instead we decide to use deferred compensation as part of the transaction we will be using pre-tax dollars instead of after tax dollars.  In this example, if you want to turn over $1,000,000 to someone to purchase their business and the payments are deferred compensation the cost of the transaction will be $1,000,000.  The buyer is now saving $800,000.

The problem with using deferred compensation is the seller will pay ordinary income taxes on the money they receive.  This is usually overcome by having the buyer up the amount that is in the deferred comp agreement to equalize the after tax effect the seller has.  In most cases this would be about 20% of the purchase price. 

Using our example above the cost for having an equalized deal would cost about $1,200,000.  This still saves our buyers $600,000 while leaving the owner with the after tax amount.

Reducing the cost of purchasing the business helps the selling owner receive the money that is owed.  And, this is the goal in any transaction.

Josh Patrick

I’ve written a special report on the seven steps of leaving your business in style.  I encourage you to click on the button below to download it.

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Topics: exit strategies, business exit planning, deferred compensation

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