Your personal income and balance sheet
As an employee, you collect a paycheck, benefits and potentially earn a bonus. You may also have some fringe benefits through an expense account. As a business owner you likely have more opportunities to benefit from the business, in terms of income as well as a boost to your balance sheet when you sell, as long as the hotel is profitable.
You should have expert advice from your tax accountant or financial planner or other financial professional as you set up this aspect of your investment.
Compensation from owning a hotel can be on a regular basis, like fees for a service performed every month. Some compensation is one-time, like selling the hotel. Some forms of compensation come out of the business above the Net Income line. These payments come out before the profits that are shared with investors:
- Salary/W2 income
- Management fees including flat fees, incentives such as a percentage of revenues or profits, and performance kickers
- Fees for specific purposes
- Lifestyle benefits like cars, club memberships, travel and expense accounts
- Family members on the payroll (and receiving benefits like in company retirement plans)
- Operating costs allocated from your investment company to the hotel
- Expenses such as insurance, bookkeeping, and other costs shared between home and work
Other forms of compensation, distributions of profit, are shared with investors according to the contract they hold with you. For instance, profit distributions for an LLC are pro rata in accordance with the terms of the operating agreement for both operating profits and proceeds from sale of the asset.
- Profit distributions
- Distribution on sale of the business
- Depreciation and non-cash losses (can be a tax benefit materially reducing your tax bill)
In addition, there may be benefits to owning a business that do not appear on the company P&L. For instance, you may have other companies that do business with your hotel.
There may be periods when the business loses money and this should also be part of your planning. It’s never good to lose money. However, if you have a period of losses, plan to get the most tax benefit from it.
Your ethics as a business owner and your risk tolerance will affect your compensation planning.
- Your investors put money into the hotel in good faith. To make the investment, they trust that you will not take money out of the business that should be distributed to all investors, including you. It is critical to be fair and above-board for your investors if you want them to invest with you again.
- Hotels can be expected to have strong years and times when they lose money (or make very little). For this reason, you may want to carry sufficient working capital to tide the business over lean periods rather than distributing funds aggressively. The alternative is to go back to your investors for additional capital during down periods.
- Each form of compensation has tax consequences and some are only legal within certain restrictions. For instance, family members on the payroll must provide legitimate services to the business.
- How your compensation is recorded has implications for the value of the property. Owners who bury benefits in their accounting records show poor financial results which can reduce the value of the hotel.
Your business and your tax bill
Tax strategies available to hotel owners are an area where your CPA, CFP, tax accountant and other experts can advise you, set your business up advantageously, and keep you out of trouble. These are strategies you may discuss with your advisors.
- Deductions: Some expenses outside the hotel itself can be deemed business related and therefore deductible.
- Timing income: When you recognize income can shift taxes from one year to another and can reduce your overall tax bill. Within two years or so of a sale, recognizing or deferring income can also impact value – for better or worse.
- QBID: The Qualified Business Income Deduction allows up to 20 percent of qualified business income from pass-through entities to be deducted for some taxpayers. However, it can reduce the benefits of some retirement plans and has specific requirements for real estate activities.
- Qualified Retirements Plans (401K/profit sharing, SEP, SIMPLE, cash balance, defined benefit plans): These plans can allow tax-deferred contributions which lower current income and related tax while saving for retirement. These benefit employees, including you, so your plan would reflect how much you want to contribute as well as the hotel’s strategy for managing payroll and benefit costs. These plans have significant differences and nuances, so professional guidance can be particularly beneficial to meeting your goals.
- Charitable Giving/Donor Advised Funds (DAF): Assuming you are charitably inclined, donating to a DAF can be a tax efficient way to set up a program for charitable giving. Once funded, you can use the DAF to give grants to charities over time. Contributions to a DAF are irrevocable and cannot be used to fulfill personal charitable pledges. Hotel owners use planned charitable giving to reduce taxes in profitable years including sale of the hotel. Highly appreciated assets – such as an interest in the business or stocks – can also be contributed to the DAF, which can maximize the tax efficiency of the donation by eliminating or reducing taxes on that portion of the investment.
- Trusts (GRATs, IDGTs, CRTs/CLTs): These instruments allow a trustee to hold assets on behalf of your beneficiaries. For hotel owners, they can be used as a component of tax planning for regular income and for capital gain on sale of the hotel. These trust strategies each have different purposes. While they can be effective, they complicate your financial situation. Qualified trusts and estates attorneys specialize in providing advice about these strategies.
- 1031 Exchange: Section 1031 of the U.S. Internal Revenue Code allows you to avoid paying capital gains taxes when you sell an investment property like a hotel and reinvest the proceeds from the sale within certain time limits in a property or properties of like kind and equal or greater value.
- Depreciation, cost segregation and asset retirement: Your hotel and all its contents wear out over time. So, the tax code lets you expense a part of your investment every year – depreciation. Because you already paid for the hotel, it is a non-cash expense. It has the effect of reducing your taxable income without reducing your cash flow (the money you distribute from the hotel). Depreciation can be a substantial tax benefit, but it can come back in the form of “depreciation recapture” and create a large tax liability on the sale of the hotel.
Hotels involve frequent capital investment and buy and use everything from furnishings to equipment to supplies. What you expense, what you depreciate, and how rapidly you depreciate it impacts your taxes. In general, expensing things (writing them off in the year of purchase) reduces taxes for that year. Similarly, classifying things in categories with shorter depreciable lives (depreciating over 5 years instead of 10 for instance) reduces your near-term tax bill. Cost segregation is an analysis that classifies each item in the hotel in the most favorable way for tax purposes.
You should have a detailed list of depreciating assets in your tax return – down to headboards and carpet. Review the schedule of assets and depreciation every year to retire assets that are not currently in use. Once retired (off the books of the business) there is no depreciation recapture at ordinary income tax rates. Instead, any gains are taxed at the lower capital gains rate.
Depreciation shows up on your tax return and below the Net Operating Income line on your Statement of Profit and Loss (P&L). This means it does not affect the calculated value of your hotel when a broker or buyer assesses the property. However, items that are expensed rather than depreciated reduce your Net Operating Income. Therefore, whether you expense or depreciate items affects your hotel’s value. Strategies about depreciating versus expensing are something to plan at least two years before you anticipate a sale.
Life after Selling the Hotel
Executives and W-2 employees tend to think in terms of retirement accounts, pensions and stock options when planning their financial future. While they may be emotionally tied to the company where they work, people moving toward retirement or a job transition get ready – often eager – to leave the corporate world.
Business owners are likely to have their identity wrapped up in the business. They are attached to their employees, feel valued by their customers and consider themselves critical to the ecosystem of their business. It takes mental preparation to sell a business you own.
It also takes financial preparation to sell a hotel – both personal and company readiness. Owners typically plan to replace income from the hotel with income from proceeds from the sale. It’s harder to plan to replace the lifestyle benefits from the hotel particularly if you don’t remember them all or their value. In addition, owners prefer to transfer the wealth accruing from a hotel sale with a minimum of tax.
A well-planned hotel sale can deliver a strong balance sheet boost to you, as the owner. In fact, bolstering your balance should be the underlying purpose of becoming a hotel owner. Planning for eventual sale is part of setting up the business. There are timing requirements associated with some tax strategies. Also, optimizing the sale affects operations and reporting well before the sale. Accordingly, implementing the sale most profitably starts about two years before the actual closing date. The appropriate the team of advisors – including broker, tax planner, accountant and attorney – assists in positioning your asset for the buyer’s due diligence and the ultimate sale.
As a business owner, you will encounter a variety of predictable risks and should plan to protect yourself and your family, to a practical degree. You’ll also encounter risks from changing legislation and other factors that you’ll hear about at industry conferences as well as from your brand, hotel associations and colleagues. As these emerge, you’ll find solutions together with other hotel owners and the experts you engage.
Entity separation: Hotel owners commonly put each hotel in its own corporation or LLC. This limits the liability from each operation. It also lets you have different capital stacks for each operation.
Insurance: Hotels typically acquire property and liability insurance in the hotel specialty market. These policies cover the special interests of hotel owners, which can include multiple insurance needs under one entity from recreational facilities to serving alcohol. Hotel insurance packages are also designed to meet the requirements of hotel franchise companies and keep you, as the owner, in compliance with franchise requirements.
Workers compensation insurance is typically a legal requirement and these policies are also carried by hotels.
The business may also carry insurance for you and other critical executives such as life insurance, disability insurance and key man insurance. Sometimes insurance is used to fund buy/sell agreements to plan for the possibility of death or permanent disability. Some owners use life insurance to cover tax liability in case of death or to equalize bequests at the death of the owner when one or more family members are not inheriting the business.
Continuity Planning: You are responsible for operations and cash flow even if you are hit with a disaster (death, disability, natural disaster). Business continuity plans prepare the business and key employees to weather the disaster. You prepare a plan so everyone knows who will be in charge and review the plan annually because there will be turnover. Your bookkeeper can keep the plan updated for you including assignment of key roles and responsibilities including instructions for management transition and:
Copies of the:
- Operating agreement
- Buy/sell agreement
- Franchise agreement
- Life, Disability, Property and Casualty, Liability and other insurance
- Source for passwords to critical operating accounts
- Financial power of attorney
- Licenses to operate the hotel (liquor license, business license, tourism permit, etc.)
- Formal written instructions for your family
Contact information for:
- Person with authority to transact on hotel accounts
- Lenders and equity investors
- Key customers and vendors
- Franchise representative
- Attorney, insurance agents and CPA
- Bank contacts and instructions for maintaining credit lines
- Second signatory on all bank accounts and safe deposit boxes