Planning for retirement is difficult for owners of small businesses. Not only do they have to plan for their personal security, they must also plan for the continued success of the business.
So, how do you, the advisor, help the owner of a closely held business cash in? You do so by developing strategies that “monetize” the business, i.e., converting the owner’s equity interest into cash, which he or she then uses to purchase goods and services throughout the retirement years.
ASSET-BASED OR CASH FLOW RESOURCES?
Businesses tend to fall into one of two designs: companies that generate cash flow and firms that consist of marketable assets or processes. The first group tends to be service-oriented, generating cash flow but having few hard assets (no land, machinery or inventory). These owners must focus on saving part of that cash flow for retirement.
The manufacturing sectors encompass the other broad group of businesses. They own land, buildings and equipment; they create and deliver a product or process. Profits in excess of a reasonable salary are often poured back into the business.
Most owners risk waiting too long before planning for retirement. The sooner you help them address the problem, the easier the solutions.
Regardless of when the owner starts, it soon becomes evident that no one method gets you to 100% of the financial goal. It takes a combination of strategies, especially if one of the goals is to keep the business in the family.
Personal Investment-The 10% Solution
This option, the simplest form of monetizing the business, calls for investing up to 10% of gross earnings each year in a varied portfolio, coordinated to address multiple risks.
The strategy offers the greatest opportunity for accumulation if started early. It puts the owner in control of investments. There are no government rules telling the owner to include employees, or limiting how much to put away each year.
This strategy is available to all small business owners, including sole proprietors, C or S corporation shareholders, partners, and members of a limited liability company (LLC).
Here are three 10% solutions an advisor can recommend:
Level term with return of premium rider. The death benefit protects against early death for 10-, 20- or 30-year term insurance. Return of premium (ROP) is available with most 20- and 30-year term options. At retirement, use the ROP to fund an immediate annuity or other income-producing vehicle. Alternatively, use the ROP to fund a single premium for a no-lapse guaranteed UL product issued under the term conversion privilege.
High cash value universal life. Choose a Sec. 162 bonus to use business dollars for the owner and an employed spouse. The owner secures an income tax-free death benefit while the cash value accumulates and gains tax-advantaged access to the cash value at retirement.
Reinvest payroll tax savings. A high income business owner can increase his or her salary so that it exceeds the Social Security wage base. The result: The owner gets a 12.4% pay increase (the savings from the Old Age Survivor and Disability Insurance (OASDI) tax portion that stops once income exceeds $90,000 for 2005).
Fund a fixed or an equity indexed annuity with the pay increase. Look for annuities that guarantee both a minimum return and monthly income benefit (check the specific insurer’s product). Keep an eye on “tax bracket creep” and the alternative minimum tax if you use this strategy.
Retirement Plans: Qualified and Nonqualified
Most owners whose businesses are beyond the start-up phase can fund a retirement plan. They can systematically move equity out of the company and into an account for their benefit, facilitating its later conversion into income. What are the options?
The qualified solution
Qualified plans create a current income tax deduction for contributions to the plan. Earnings grow tax-deferred. Most plans allow a rollover to an IRA at retirement, permitting the plan participant to self-direct the investments and requiring only minimum distributions.
To enjoy those tax deductions, federal law makes owners follow certain rules about including employees, limiting contributions for higher paid owners and restricting permissible investments. However, these plans are available to all forms of business–corporation, self-employed and partnerships or LLC.
First qualified solution: add life insurance. Supplement profit-sharing, money purchase and defined benefit plans with cash value life insurance. There are strict limits on how much of each year’s contribution can go to life premiums. To the extent that the death benefit exceeds cash value, the owner’s surviving spouse will enjoy an income tax-free benefit when death occurs before retirement.
Second qualified solution: rollover IRA. Annuities work well for rollover IRAs. Owners enjoy control over investments and withdrawals. By combining immediate and deferred annuities, they can meet minimum distribution rules while stretching their nest egg over their retirement years.
A Nonqualified Alternative. A non-ERISA plan offers greater flexibility, with the ability to select who participates, how much they get, and when they get it. If desired, you can take care of the owners solely.
Nonqualified means that you escape ERISA. It also means no current tax deduction. The company deducts benefits as compensation only when they are paid. Also, there is some risk to the accumulation account from attack by general creditors of the company.
This alternative retirement plan works best for owners of C Corporations. However, as long as the plan is not based on salary deferral, it can benefit owners of S corporations, partners and members of an LLC. Salary deferral plans do not work with these entities because they pass-through their income and expenses to the owners.