Helping Owners Cash In

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 [email protected].