Personal Financial Planning Strategies and Tips for Small Business Owners and Entrepreneurs
Most business owners and entrepreneurs face an ever increasingly competitive and rapidly changing business environment with an incredible number of issues demanding their time, focus and headspace. Oftentimes their own personal finances don’t get the focus and time needed. Here are some strategies and tips for business owners that can help them make progress on their personal financial goals, save them money, and de-risk the impact of their businesses on their lives.
Traditional Retirement Planning Doesn’t Work for Most Business Owners
Traditional retirement planning doesn’t usually apply to many business owners. Many owners have most of their net worth tied up in their business, and have their transition into retirement tied to an exit event far into the future. Other business owners are so focused and passionate about their business they don’t ever plan to stop working in their business. In either case, we recommend a two-pronged approach: modeling projections around the savings necessary to achieve financial independence from passive investments outside of the business, and also modeling scenarios that incorporate various timings and valuations of an expected business monetization event to determine what after-tax sale price is necessary to maintain the owner’s lifestyle.
While the line between personal and business expenses isn’t so clear to many owners and entrepreneurs, it’s important for the projections to work toward determining the entrepreneur’s true living expenses. Travel costs, computers, vehicles, and a host of other expenses are likely being subsidized by the business, and owners are living on a combination of pre-tax and after-tax expenses.
Business Structure Will Affect Your Personal Financial Planning
How and where the business owner forms the business can impact a business owner’s financial planning for years to come, and a CPA, an attorney, and a CFP could all have different answers when it comes to deciding the optimal business structure. Many CPAs advocate for S Corp status since there could be FICA tax savings by paying the business a salary below the Social Security max salary. On the other hand, an C corp might be attractive to a business owner that will sell his or her business for a large capital gain if the business qualifies for Section 1202 qualified small business stock and receives a capital gain exclusion of up to $10 million or 10 times basis if certain qualifications are met. Many attorneys will advocate for legal flexibility that an LLC provides, but even the state of LLC formation could impact the business owner personally. An LLC formed in New York will potentially subject the business owner to more business formalities, greater regulatory supervision, higher franchise taxes, a heightened fiduciary standard, higher formation fees, greater rights of minority investors vis-a-vis an LLC formed in Delaware.
Be Thoughtful about Deciding Your Salary
Depending on what a business owner is trying to accomplish, the right answer on what your salary should be varies greatly. Minimizing payroll taxes means drawing as little a salary as possible in theory, but that can have other consequences like running afoul of the S-Corp reasonable compensation rules. Some business owners aim to draw enough salary up to the maximum amount of earnings subject to taxes from Social Security ($137,700 in 2020), since this maximizes your Social Security benefit down the line. Another consideration for pass-through entity owners is potential tax savings through Section 199A (qualified business income). It makes a lot of sense to work through calculations with your CPA to determine the salary that maximizes their QBI deduction.
A business owner’s personal financial planning savings strategies should impact the salary number as well. For example, you may be able to put away the maximum $57,000 in a 401(k)/profit sharing plan with a salary of $150,000 (2020) or more, but it takes $285,000 (2020) to receive the maximum defined benefit in a cash balance plan. While saving money on taxes should always be considered, the personal liquidity needs, expenses, and goals of the business should always take precedence. It’s a common occurrence for many business owners having issues buying a home they want because they were too aggressive maximizing deductions and showing as little income as possible.
Maximize Tax Deductions, but Stay Focused on the Business
While business owners don’t need to become tax experts, business owners should learn the basics and engage tax experts to help them navigate the constantly evolving rules so that they can minimize their tax liability. There are many tax opportunities that business owners and entrepreneurs just aren’t aware about. For example, giving to charity through sponsorships through the business can be much more tax efficient than donating to charity and taking a personal deduction. Section 280A allows business owners to rent out their personal residence for up to 14 days without declaring the income, and meanwhile the business gets a deduction. As well, business owners should generally be looking to shift income to lower rates, whether that’s shifting income to children in lower tax rates through summer employment, shifting income from salary that pays FICA to rental income that doesn’t, or possibly changing entity structure altogether.
In almost every major expense category, there’s likely an opportunity for tax savings through one strategy or another, but there could be unintended negative consequences, heightened aggravation, or audit scrutiny. For example, taking a low salary can save on FICA taxes, but you’ll likely end up with a lower Social Security benefit later in life. Likewise, changing your personal residence from New York City to Florida could probably save you a bunch on state and city taxes, but the burden of proof remains with the owner to prove that it’s a bonafide residency chance and moreover, the process could backfire if it’s disruptive to the business.
Build a Strong Personal Emergency Fund
Let’s face it, business owners and entrepreneurs have the potential for more unforeseen and uncontrollable risks to their personal financial life than employees. Economic downturns, consumer tastes changing, industry trends, tradewars, legislative changes and so many other factors could impact business owners’ ability to draw income from the business and stunt personal financial progress. While each business owner’s situation is different, generally having 3 to 6 months of personal expenses in a personal emergency fund outside of business may not cut it for most situations and larger cash balances may be needed to combat potential business risks. Business owners should analyze the trade-off of holding low-yielding cash in an emergency fund versus the investment opportunities in their portfolio and in their business. To the extent these risks are mitigated through extensive insurance coverages, large untapped lines of credit, a strong market position, diversified revenues streams, industry growth prospects, better than average management, or other reasons, a smaller emergency fund may be appropriate.
Manage Debt and Contingent Liabilities
Business owners may have significantly more debt and potential liabilities than they realize, and should take steps to minimize potential risks. Many business owners increase the risk profile of their personal finances by personally guaranteeing business debt and/or allowing liens on their home or other personal property. Processes should be in place to think through these and other risks like entering long-term agreements, such as software vendors or suppliers. Company vehicles and real estate are particularly troublesome areas if proper coverages are not in place. An accident in a company car or at the office can lead to a potential lawsuit, and plaintiffs usually go after the party with the deepest pockets. Owners should plan around the reality that the activities of employees can affect their personal lives financially, including harassment and discrimination in the workplace. Employee credit cards can also put the owner at unnecessary risk if the right procedures aren’t in place. Even employee benefits can put owners at risk. A pension plan that’s invested inappropriately or implemented with onerous fees can be a source of liability for the business owner trustee of the plan. Having the right team to address regulatory and compliance in your industry, and tax risks is paramount.
Not every risk can be eliminated, but a disciplined approach to identifying risks, internal processes to mitigate risk, responding quickly to risks as they arise, and a business owner policy that provides coverage that addresses internal and external risks is highly recommended. Business owners should look closely at business interruption, vehicle, cyber, product liability, professional liability, errors and omissions, and other types of coverages. Business owners with co-founders and partners also have to address that they are liable for each other’s actions.
Strategically Allocate Personal Capital to Address Concentrated Wealth
Many business owners are comfortable with such a high concentration of their net worth in their business for a variety of reasons. It may be the confidence they have in the business’s prospects or the vast amount of direct control over the business’s financial success they exert relative to other investments, like the stock market. Moreover, many businesses have rates of return far in excess of typical long-run market returns, so diversifying outside the business may not make much sense in those types of scenarios. Given the array of uncertainties to businesses and consequently most business owner’s future income, we highly encourage entrepreneurs to keenly look at how they are allocating their personal capital between reinvesting in the business, the living expenses, their emergency fund, and investments outside of their business to mitigate risk and achieve financial independence.
As a business owner builds wealth outside her business, it’s important to be mindful of some common pitfalls. There’s a tendency for many entrepreneurs to invest in what they know, but a business owner that invests her personal capital portfolio predominantly in angel investments in their own industry or publicly traded companies in that industry isn’t mitigating as much risk as intended. Other novice investments may aggressively chase investment trends. A solid investment plan with a truly diversified portfolio of liquid stocks and bonds is the key to combating the risks of concentrated wealth. As well, business owners oftentimes are used to tracking their profit and loss statements closely and making adjustments in real time. This approach may not work as well with liquid portfolio investments, as constantly tweaking and reacting to market conditions often results in counterproductive market timing and tax inefficiency.
Another common way to build wealth outside of the business is through real estate. The business owner may even consider buying real estate and renting it back to the company. That way the business gets a deductible expense, the owner builds equity, and there’s increased financial flexibility with a more diversified personal balance sheet. We also recommend getting a business valuation periodically and tracking the valuation over time. Analyzing why the business valuation is growing quickly or contracting can help with business planning and personal capital allocation decisions.
Implement and Plan a Succession/Exit Plan
Our experience is that a successful exit from the business can sometimes take years. Oftentimes, business owners have a vague idea of the timing and amount they need or want to exit the business. We recommend owners go through a formal exit planning process. It starts with getting a formal business valuation and evaluating personal, financial and business readiness to exit the business. Then the owner should have an action plan to get the business ready for transition and plan to understand the range of options and likelihood of success, whether it’s transitioning the business to the next generation, a sale to an employee, a sale to a third party, or just closing the business down one day. Some of the main issues to address in getting the business ready for a sale would involve having the business less reliant on the business owner, systematizing as many of the business processes as possible, and having a plan to retain key employees.
Estate Planning Issues Have Heightened Importance
The stakes are potentially much higher for business owners, since many more people in addition to the owner’s family could be reliant on the owner for their livelihood and success. Owners don’t just have the traditional documents like wills, powers of attorney and a health proxy, but also advanced estate documents for asset protection that may include additional LLC and trust structures, and possibly advanced succession estate planning documents as well. As owners think through their estate plan, how assets are titled really matter, and moreover, coordination with existing documents like operating/shareholder agreements and buy/sell agreements should be investigated.
For business owners with a net worth above the Federal estate exemption, significant planning and coordination with the owner’s attorney, financial advisor, insurance broker, and CPA needs to be completed so that large estate taxes are avoided. Worst case scenario is that a business owner dies unexpectedly without an estate plan, and the business has to be sold at a highly discounted price. The optimal estate plan would minimize taxes and maximize transferring assets to family and causes the business owner cares about.
David Flores Wilson, CFP®, CFA, CEPA is a New York City-based CERTIFIED FINANCIAL PLANNER™ Practitioner & Managing Partner at Sincerus Advisory. Click here to schedule a time to speak with us.