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.
The ability to secure the owner’s retirement depends on their ability to realize maximum value upon sale to a third party. The type of business will indicate which option will work best.
Survey of Top 5 Retirement Hazards
1.Outliving income and assets
2.Death of a spouse
4.Interest rate risk
5.Stock market risk
Source: Society of Actuaries, Post-Retirement Risk Chart, 2003.
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.
Nonqualified deferred compensation plans take one of three forms:
o Salary deferral by the employee (similar to a 401(k) plan);
o Supplemental plans funded by the employer and designed to replace benefits lost to ERISA limits;
o “Top hat” plans funded by the employer, which pay a defined benefit at a future date, often tied to individual or company performance.
Possible Nonqualified Solutions. A nonqualified plan does not require funding by the owner. In fact, most funding is informal. Assets are earmarked for future obligations while remaining accessible by the company and its creditors. (Beware: the pending rules under IRC 409A may impact this issue.)
1. Select a high cash value universal life product and fund it with a target premium just short of an MEC. Include either the intermediate or lifetime no-lapse guarantee (NLG) if appropriate.
2. Level term (with return of premium) offers a cost recovery technique when the owner insists exclusively on equity solutions for informal funding.
Sale of the Business
When monetizing a business, you have three options: fund a retirement plan for the owner (already discussed), sell to a third party or liquidate. Selling at fair market value is always preferable to liquidation.
With a change in ownership, the owner must determine whether to sell to existing co-owners or an outside party, or keep the business under family control.
Getting fair market value. The immediate problem when selling a business is how to secure a buyer and assure a fair price.
A buy-sell agreement is a traditional arrangement when the sale involves co-owners or outsiders. Any type of business can be sold using a buy-sell arrangement between the parties. Securing the arrangement with life insurance in case of death solves only 10% of the owner’s problem.
The real problem is the “90% problem”–how does the owner get paid during his or her lifetime? Unfortunately, most buyers of small businesses don’t have access to bank financing. So, the owner is forced to finance the deal himself.
However, there is a risk if the sale is not a lump sum. Installment payments may end before life expectancy, so the owner will need to reinvest some of the payment each year for future retirement needs.
Also with installments, the continued income stream depends on the buyer’s ability to run the company successfully and pay the seller. Business brokers can help spruce up business to secure maximum value.
Keeping it in the family. Different problems arise when the family retains the business. The senior family member could sell part of his interest to the younger successors in exchange for a promissory note, using the interest as a form of retirement income. However, the challenges are similar to a sale to non-family members (e.g., how to provide for both the new owners and the retired owner).
Family businesses have other options, especially when the retiree wants to remain semi-active. The business can direct income to the retiree by means of salary as a board member or semi-active officer. Consulting fees are an alternative, with most contracts paid for three years after retirement. Partial sale of the business interest is another option for raising retirement cash.
There are other strategies for getting cash out of the family business. Among them:
Transfer C stock to a tax-exempt trust. With sufficient cash reserves, the business can redeem C stock transferred by the owner to a charitable remainder trust (CRT). The sale by the CRT back to the business escapes current tax on the gain.
As the income recipient, the owner enjoys an income (5% to 7% on average) from the CRT for life. And he gets a current income tax deduction. Use life insurance to replace the stock transferred to charity for the family.
Long-term lease. If practical, the retiree should own the land and buildings used by the company. He or she enters into a long-term lease (20 to 40 years) with the company. The retiree enjoys rental income far into the retirement years, while the business secures its operational base. This option is open to any business.
The 1042 Rollover-Employee Stock Ownership Plan (ESOP). Only C and S corporations need apply. Owners sell their shares to the ESOP at retirement for a lump sum or installments at a price fairly determined by a qualified valuation expert. If the seller purchases “qualified replacement property” (QRP) within 12 months of the sale, no capital gain is recognized. What is QRP? Any publicly traded stock or equity.
The seller benefits from portfolio diversification, and can choose when and what to liquidate for retirement income needs. Family members continue the business as both owners and trustees of the ESOP.
Life insurance plays a key role in ESOP planning. A bank usually loans funds to the ESOP to buy out the retiring owner. The ESOP buys life insurance on the owner to pay off the loan.
Summary. No single method will accomplish 100% of a business owner’s retirement objective. By combining several strategies from now until retirement, savvy owners can exit successfully from an active business role and enjoy the fruits of their labors.
Life insurance is a good “sixth man” retirement strategy. It should never be the owner’s sole means of support, but he or she should not go without it. The favorable access to cost basis rules, power of the death benefit as survivor income and tax deferral on internal growth make it a strong player in the owner’s ultimate retirement strategy.
John A. Kruse, Jr., JD, CLU, CPCU, ChFC, FLMI, engages in retirement and business planning in association with the Financial Legacy Group, Cincinnati, Ohio. You may reach him at Kruse_John@nlvmail.com.