When calculating Net Wealth for business owners, there are a few important considerations many people don’t take into account with their business. This is especially important for business owners, as the largest asset they own is usually their business. Many people will tally up their total assets, including what they think their business is worth, and then subtract the commonly thought of liabilities, usually credit card debt and any loans they might have. While this is a good start, there are three main problems with this calculation.
For starters most retirement accounts, 401ks and IRAs, are tax deferred, meaning you will have to pay taxes on the withdrawals from these accounts. This is taxed at Ordinary Income rates, between 20% and 35% depending on the tax bracket, so a liability will need to be created for the deferred taxes on these retirement accounts. As an example if you had $500,000 in these retirement accounts and your tax bracket was 24%, you would have a liability for $120,000 in deferred taxes, so the retirement account would have a net worth amount of $380,000.
Another is the value of the business is often overstated by the business owner. This happens due to a variety of factors, an emotional attachment to the business, or a lack of proper research for industry comparable transactions or the industry as a whole. Occasionally, even if a sale price can be agreed upon by the business owner and a prospective buyer, the value might not be able to be achieved if the bank supplying the financing for the purchase won’t loan based on the agreed price as the bank disagrees with the valuation. Therefore the value of the business might only be what the bank is willing to lend on it. This is a good reason to get a 3rd party, unbiased valuation of the business as it will both help set expectations for the owner as well as allow better retirement planning with a more realistic number to use.
To realize the value of their business the owner will have to sell the business, which will incur income/capital gains taxes as well as a broker fee if they have a business broker/banker assist in the sale of the business. The taxes can range from 20%-30% of the sales price and the broker fee 5%-10%, so after completing the sale of the business, the owner will likely have to pay 25%-40% of the sale price. This can be a significant amount of money and needs to be taken into account both for a net wealth calculation as a liability and for retirement planning. As an example for a business worth $1,000,000 the net take home amount for the business owner after paying these taxes and fees would be between $600,000 and $750,000, a far cry from the $1,000,000.
When calculating a true, accurate Net Wealth for business owners, you need to account for deferred taxes on retirement accounts, an unbiased valuation on the business as the business owner usually overstates the value, and the taxes and broker fees that come along with selling a business.
Written by Robert Rusnak