The Stealth Benefits of Business Ownership
The year John F. Kennedy was elected President of the United States, Sam and Emily moved their two-year-old business from a $100,000 rented facility to a $50,000 building they purchased. They had saved the $7500 down payment necessary to qualify for a commercial mortgage from the bank for the remainder of the purchase price.
Even with the down payment, which was their life savings, the $336 monthly payment, together with insurance, taxes and maintenance, still totaled $500 more per year than the rent they had been paying. Some of their friends questioned this business decision.
Two Kinds Of Dirt
The year Neil Armstrong brought back some moon dirt, Sam and Emily had an opportunity to purchase two-acres of earth dirt adjoining their corner location, for $60,000. They didn't need the land that year, but their business was established in a good location, and they believed expansion was in their future. Using their existing property as partial collateral, Sam and Emily purchased the lot next door, as family and friends scratched their heads over why they would buy dirt they couldn't use.
The OPEC oil embargo was taking its toll on the economy a few years later when one of Sam and Emily's competitors lost his lease. This, combined with inadequate reserves to ride out the economic downturn, caused that business to close. Seeing an opportunity to accrue quick growth as a result of the competitor's demise, our entrepreneurial couple started construction on the two-acre acquisition immediately.
Now almost one third paid for, and with five years of property appreciation, the land value by itself was more than enough to qualify Sam and Emily for a commercial mortgage to finance the new expansion. And as they believed, their sales more than doubled with the new addition.
An Unexpected Opportunity
As President Ronald Reagan was assuming his second term, some friends of Sam and Emily, a couple who owned a business just like theirs in another part of the state, decided to retire, and offered to sell to them. With both of their children, Elizabeth and Sam Jr., now working in the business, the cross-state expansion was a logical consideration, but it presented two financial challenges: 1) the purchase price; and 2) the expansion working capital.
Both of these financial challenges were well beyond Sam and Emily's liquidity and working capital resources. In the comprehensive review of all available leverage opportunities with their CPA and bankers, Sam and Emily were told that, while their business's balance sheet exhibited impressive equity numbers, that alone would not be enough to justify the financing needed for the acquisition. But there was more. They were told that they had two other very valuable assets working for them:
- A 25-year track record of disciplined business management that translates to major character points with bankers, and
- Three acres of now-prime real estate, holding up 15,000 square feet of income-producing improvements, together appraising for $775,000, and -- here's the really good news -- all now paid for.
Combined with their business's balance sheet, these two "assets" would be enough to put together this very exciting, but for Sam and Emily, unprecedented, acquisition.
Forty Years Of Stealth Benefit
For forty years Sam and Emily took advantage of the stealth benefit of business ownership: Owning the real estate on which the business operates. There are three primary elements that kept this benefit below the radar until they needed it:
1. Equity accumulation -- Two really cool things happen when you make payments on a commercial real estate mortgage: 1) Equity accumulates pretty fast because commercial mortgages are typically amortized for no more than 15 years; and 2) In terms of asset appreciation, income producing real estate has few rivals. For Sam and Emily, these two cool real estate ownership features popped up on their problem-solving radar on several crucial occasions.
2. Investment income -- When a business occupies commercial space, somebody gets the rent. If you own the real estate that houses your business, that's you. And while rents increase year after year, your payment typically won't, resulting in investment income, but more importantly, positive cash flow.
Most financial advisors recommend that the business real estate should be held by the business owner personally, instead of on the business's balance sheet. That's what Sam and Emily did and, as you have seen, this strategy paid dividends over many years.
3. Tax avoidance -- Tax evasion is illegal; tax avoidance is not. Even after the Tax Reform Act of 1986, income producing real estate delivers tax shelter for those at risk for the associated debt. Furthermore, every dollar of personal W-2 income a business owner/landlord can convert to rental income is a dollar not subject to payroll tax. By maximizing the rent their business paid them over 40 years, based on local market rent comparables, Sam and Emily were incrementally -- and legally -- able to put their tax-avoided dollars to better use.
On the matter of tax avoidance, here's what one of the preeminent legal minds of the 20th century had to say about tax evasion and tax avoidance. This quote is slightly edited for brevity:
"If I went over a toll bridge and through the barrier without paying the toll, I would be committing tax evasion. If, however, I take another route, which takes me over a non-toll bridge, I am using a legitimate, logical and suitable method of tax avoidance. For my tax evasion, I should be punished. For my tax avoidance, I should be commended. The tragedy of life today is that so few people know that the free bridge even exists," wrote Supreme Court Justice Louis D. Brandeis.
Where Are They Now?
With estate planning counsel from their financial advisors, Sam and Emily recently retired. The children now own the business, with Elizabeth running the flagship location, and Sam Jr. in charge of the acquired operation.
The business, though now part of a mature industry, is still doing pretty well. And one of the principal retirement income sources for Sam and Emily is the rent the company pays them on the property in which their children now make their living.
Epilogue
The Sam and Emily story is a fictitious composite of literally millions of very real stories being played out by small business owners. In the small business risk/reward dynamic, real estate ownership is one of the most prominent factors.
It doesn't take long for a new small business owner to realize that the professional direction they have chosen is not a quick ticket to wealth, nor does business ownership automatically come with a big monthly paycheck.
Wealth accumulation and handsome income happens to most small business owners only after lots of hard work, years of disciplined management, and dedication to something they love. And one of the critical components of wealth and income is taking advantage of the stealth benefit of business ownership: Personally owning the real estate your business operates in, and being your business's landlord.
Write this on a rock... Maturity as a small business owner comes when you realize that wealth accumulation in your chosen profession manifests in multiple forms. A critical aspect of your role as master of your own financial fate is to find and maximize the benefit of as many of these forms as possible.
Jim Blasingame
Small Business Expert and host of The Small Business Advocate Show
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