Whether your business is worth $200,000 or $20 million, guess what? You’re not. Your company is just a highly illiquid asset that provides you with a paycheck. And yet, if you’re like a lot of entrepreneurs, 100 percent of your wealth is attached to your business -- leaving you doubly exposed to financial disaster. If it fails, you’ll lose your current and future income. “Entrepreneurs need to realize that their worth -- and financial future -- is predicated on their personal assets’ ability to generate income,” says Elisabeth Cullington, managing director of HoyleCohen, a San Diego-based wealth advisory firm.
How to do that? It seems obvious: Pull out as much money from your business as you can. But that’s not so simple. Giving yourself a raise or a large bonus just increases what you’ll owe the IRS. You’re better off with one of the following options.
If you have more than 20 employees, you have enough to safely set up an employee stock ownership plan (ESOP). While this is technically an employee benefit, it’s also one of the most tax-effective ways for a business owner to tap into equity without losing majority control of the business, Cullington says.
Think of it as a partial sale -- but instead of an outside investor, your employees essentially become your partners. It’s good for all: You’ll free up cash that can be reinvested (oftentimes tax-deferred indefinitely) to further expand your personal assets, your employees will have an incentive to work harder and you’ll still have a job. The cons: They’re complicated and expensive to set up, there’s an annual fee to maintain them and they can only be used in C or S corporations, not partnerships.
Create a pension.
Solo-preneurs and owners with a handful of employees should look into a defined-benefit plan. This is a modified pension plan that enables you to take out chunks of cash (for some, up to $210,000) from your business’s net profits each year. And it’s tax-free, because the IRS views your contributions as business expenses. “Essentially, it’s a retirement savings do-over for an older business owner who neglected to diversify,” Cullington says.
How it works: A formula determines the income needed to replace your current salary when you call it quits. Required annual contributions are then set for you. The shorter the period to retirement, the more you are allowed to save. One of Cullington’s clients moved more than $2.5 million from his business into his retirement savings without touching his company’s equity. Bonus: The payments cut his corporate tax liability in half!