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Do You Have an Endgame?

Posted on Monday, May 2nd, 2005 by

Whether you’re planning to sell your business or pass it along, thoughtful strategy now will pay dividends later

Small business owners contemplating retirement often find themselves torn between wanting to enjoy the relaxation and family time retirement offers, and desperately wanting the company they founded and built to continue on without them. Who wants to have spent years painstakingly building a firm and a name only to see it shuttered as soon as you leave?

Small business owners face a myriad of options when deciding who should carry on their businesses after they depart. Ownership transfer arrangements can be structured in a wide variety of ways, depending on the manner in which the business has been organized. In a company with multiple owners, buy/sell agreements are the most common form of succession pre-arrangements. Usually, these agreements divide the business up into ownership shares distributed among the partners in the business. Upon the death or departure of a partner, the remaining partners have the option or obligation of purchasing his or her share of the business. Very often, these arrangements are funded with life insurance policies held by the company on each of the partners. In the event a partner dies, the benefit from the insurance is used to purchase that partner’s share of the business from his or her estate. If the partner retires, the cash value of the policy can also be used to fund the purchase of his or her share.

Plan Ahead
“The best succession plan is to have a succession plan,” advises Walter Ridlon, vice president of New York Life Insurance Company, which helps small business owners set up and administer a variety of plans for succession and retirement in addition to offering insurance products to protect key employees. “Laying down the specifics of what you want to happen well beforehand greatly reduces uncertainty for both yourself and your employees.” It also will prevent disruptive and needless disputes among partners, employees, and family members.

Business consultant Brent Dees, president of Brent Dees Financial Planning recommends taking into account the “Four Ds of Leaving,” namely divorce, death, disability, and departing. Small business owners must give at least some thought to what will happen to their business if any one of these should happen. Dees points out that, statistically, disability is more likely to occur than death. Though some small businesses acquire insurance to cover the disabling of key personnel, many don’t, leaving those businesses vulnerable if tragedy strikes.

Determining What You Want
Succession plans depend entirely on what the owner wants. Not all small business people will be comfortable completely detaching themselves from the company they worked so hard to build. In that case, the transition can be managed with the original principal slowly delegating power to a designated successor over a period of time. Alternately, the original owner can elect to stay on at the business in a less involved position or as a consultant for a period of time after the business has changed hands. Such arrangements need to be carefully negotiated and spelled out in writing to avoid future disagreements, advises Dees.

If, however, you want to enjoy the full benefits of retirement and are willing to surrender any involvement in your business, then you will have to decide to whom you will hand the company reigns.

Who Gets the Firm
If a small business owner wants to pass the business to a member of his or her family, then the succession arrangements boil down to drawing up an equity transfer agreement under which the owner transfers his or her ownership in the firm to the designated family member or members. The Small Business Association (SBA) reports that almost 90 percent of all U.S. businesses are family owned, but that only 30 percent of family-run companies succeed to the second generation, and only 15 percent survive to the third. If a family member isn’t available or willing to continue the business, the owner will have to look elsewhere.

If the owner wishes to sell his business, the first place he should look is inside his office, says Gary Schine, partner at Merfield & Schine. “Can you groom an employee to take over? The SBA loves to loan money to employees who are buying the business they work for.” Selling the business to an employee appeals to many business owners since their company will continue on under the management of someone they already trusted enough to hire. Better still, Schine argues, the employees already know how to run the business. They have seen its inner workings close hand, have relationships with customers and clients, and know the sorts of difficulties they are likely to face running it.”

If an owner sees no potential successors among his or her family or employees, an outside buyer must be found. When looking for an outside buyer, the small business owner must keep a few important things in mind. “What will a potential buyer do to the firm? Will the current employees be kept? Or will the business be folded into the buyer’s existing operations?” Schine says. How you want to see your business go on will help determine which buyer you select.

What’s It Worth?
Before a business can be sold, or equity in the business transferred from one person to another, the market value of the business must be determined.

“We strongly advise small business owners to get a professional to perform business valuations,” says New York Life’s Ridlon. There are any number of formulas to determine a business’s value, he says, but most are complicated and require some financial skill. More importantly, setting a business’ value has important tax implications. Should the IRS question the valuation, it’s best to have an independent source for the valuation. “You’re paying for an expert’s testimony that your valuation was accurate.”

Making sure the business has obeyed the strict letter of the law is another important issue. “A lot of entrepreneurs tend to let things slide when it comes to following exactly every rule and regulation that they are legally supposed to adhere to. Environmental laws are a good example,” says Schine. “It isn’t enough to follow the spirit of the law, or to follow the law ‘pretty well.’ That’s not going to convince a buyer, who will become liable for any violations upon purchase, and it certain won’t convince his lawyer.” If your business is not in strict compliance, get into compliance, Schine says.

Retire Right
While many small business owners may hope to fund their retirement through the sale of their business to employees or partners, for most small businesses that simply isn’t a realistic option. Furthermore, with ever greater numbers of people launching their small businesses as a second career, many small business owners are facing the prospect of looming retirement with relatively few years to contribute to their 401(k) plans. The same problem looms in the minds of professionals who have spent years slowly building their medical, consulting, and legal practices into highly successful enterprises and now find themselves wondering if they’ll have enough investment income to retire comfortably. One potential solution for such high-income earners comes in the form of defined benefit pension plans, such as 412(i) plans.

Defining Defined Benefit
Defined benefit pension plans are employer-sponsored retirement plans whose future benefits are calculated ahead of time and paid out at a predetermined rate and schedule. Under a 412(i) plan, a small business owner can make fairly large, tax-free yearly contributions to the plan, which is funded with a combination of life insurance and annuities, or annuities alone. Unlike traditional pension plans, 412(i) plans permit a much higher yearly contribution, as high as $300,000 or more, which permits the beneficiary to build up a sizeable retirement investment much more quickly than would otherwise be possible.

“Defined benefit plans allow the larger contribution because the life insurance and annuities that fund the plans have a guaranteed rate of return that is generally much lower than in more traditional plans like 401(k)’s,” explains David B. Mandell, principal at Jarvis & Mandell LLC. “The guaranteed rate of return in these plans usually ranges between one to three percent, as opposed to four to six percent or more in a typical pension or retirement plan. In the latter, the employee’s contributions are invested in market-traded securities, which can generate a much greater return, provided that market conditions are favorable.” Defined benefit plans base their future value on actuarial data compiled by insurance companies, which calculate the likely life expectancy of the plan participant and structure the plan to pay out a predetermined distribution according to how much income the participant estimates he or she will need after retirement. The annual contribution (or premium) to the plan is determined by the desired size of future distributions.

Reducing Risk
Avoiding market risk is a major advantage of 412(i) plans, says New York Life’s Ridlon, “Because 412(i) plans are funded exclusively through life insurance and annuities, the risk is moved from the employee to the insurance company that issues the policy,” he says. “Future contributions to the plan don’t go up or down with the market. That provides a lot of peace of mind during retirement.” But what happens when a beneficiary exceeds his estimated lifespan? “That’s the insurance company’s risk,” laughs Ridlon. “The plan keeps paying the predetermined benefits as long as you live.” If the plan owner dies before his anticipated life expectancy, the plan’s benefits can be paid to the owner’s survivors if desired.

TERMS TO KNOWDefined Benefit Plans:
Employer-funded retirement plans with fixed future benefits. Contributions are calculated to fund the desired future income.Defined Contribution Plans:
Employer-funded retirement plans with specified contributions. Future income from such plans varies based on the performance of the plan’s investments.Annuities:
An investment that guarantees a series of future payments over a specified period of time, usually marketed by insurance companies.Key Employee Insurance:
Insurance policies taken by the company on any highly important employee. In the event of the employee’s death, the policies cushion the business against recruitment and retraining costs. If the employee resigns, the policy’s cash value can be redeemed by the firm.Term Life Insurance: 
An insurance policy that pays its face value only in the event of death.Whole Life Insurance:
A term life policy coupled with an investment component that builds cash value that can be borrowed against. Considerably more expensive than term life policies.


High Income, High Contributions
Contributions to 412(i) plans are fully tax-deductible, a prospect that attracts the interest of many business owners. “412(i) plans allow for the largest pre-tax contribution of any qualified plan,” observes Clint J. Lowery, executive case director at The Hartwood Group, which specializes in creating defined benefit plans. “Custom designed 412(i) plans allow a small business owner to retain the highest percentage of contributions for his or her own benefit.” However, Lowery explains that the advantages of such plans only accrue to small business people with fairly high incomes. “412(i) plans must be funded in equal amounts every year. A person who is highly uncertain about having consistent revenue over, say, the next five years should not consider a 412(i) plan.”

New York Life’s Ridlon agrees. “Principals in a company who wish to start such a plan should have an income of about $300,000, or more.” There is no minimum contribution or age at which to start a 412(i) plan, Ridlon explains. However, given their constraints, defined benefit plans generally work best for principals who are 40 years or older, who have relatively few employees that they wish to include in the plan, and who are willing to contribute at least $60,000 a year to the plan. For these reasons, Ridlon says, 412(i) plans are particularly applicable to professional practicioners such as lawyer, dentists, and physicians.

“These plans usually work best when the company owner is 10 years or less away from retirement and is considerably older than his employees,” Mandell observes. Moreover, he says the stability of business income is an important factor. Since 412(i) plans are funded through insurance and annuity contracts, the yearly contribution is set at the outset of the plan and generally remains inflexible. If a business suffers financial reversals and finds that its annual revenues can no longer cover its contributions, termination of the plan is the usual result.

“Every company builds its own provision inside the policy to allow for business hardship,” Hartwood’s Lowery says. “Usually the plan would be terminated. Any annuity portion would be rolled into an IRA and any whole life policy would be converted to a universal life policy.” Whole life policies feature fixed premiums; univeral life policy premiums can be adjusted to meet circumstances. However, Lowery points out that the annual contribution to the plan does not have to come solely from a company’s revenues. “The money could come from retained earnings, a contribution of capital from the owner, or even a loan. “If the company does not have enough revenue to take the full tax deduction for the contribution in the current year, the left over amount will carry forward.”

Defined benefit plans are not just for high income business or professional practice owners themselves. Employees can be included in the plans. “Depending on the business, it can be very expensive to cover all employees,” explains Ridlon. “A dentist or a doctor might want to cover the nurses in his or her office, but not the other workers.” In that case, specific formulas govern the number of employees that may be excluded from the plan.

IRS Changes the Rules
In the past few years, 412(i) plans have been subjected to scrutiny from the IRS, which issued revised rules governing such plans in February 2004. The IRS action was designed to target what it considered abusive transactions relating to the life insurance policies that fund the defined benefit plans.

“What was happening was that some insurance companies started promoting 412(i) plans as a means to purchase very large life insurance policies through tax-deductible contributions, with the idea that the plan participant could purchase the insurance policies at retirement at an artificially low cash surrender value. That value would usually be much lower than the contributions that had been paid into it,” Mandell says. “Such plans were designed to deliberately suppress the cash surrender value just at the time the participant was ready to purchase the plan, and then increase significant immediately after it had been transferred to the participant.” This meant that when a participant retired and purchased the insurance policies in his plan, he or she paid taxes based on the depressed cash surrender value of the policy, rather than its true market value.

The new IRS rules mandate that the cash surrender value must now be at least the aggregate of the contributions, minus costs and fees, made to the plan over its life. The IRS also cracked down on using excessive amounts of life insurance to fund 412(i) plans. “These schemes violated the conservative nature of 412(i) plans,” Mandell says. “The IRS has simply discouraged unscrupulous insurance salesmen with this rules change,” he adds.

The IRS action has not diminished interest in 412(i) plans, according to Hartwood’s Lowery. “The IRS clarified once again for the marketplace what type of plan design is considered to be in compliance and “safe harbor.” Lowery says the IRS has not indicated any further scrutiny of 412(i) plans is forthcoming. New York Life’s Ridlon agrees. “The IRS rulings on 412(i)s last year were focused on companies that pushed ERISA guidelines with outright illegal and inappropriate plans. It cooled off people promoting these kind of tax schemes.” Interest in 412(i) plans promoted by reputable companies remains strong, Ridlon affirmed.

Retirement Isn’t Always the End
Building a legacy matters to many small business owners. As they look forward to their retirement years, they hope to insure for themselves a comfortable standard of living, while being secure in the knowledge that the business they created will continue on after they leave. Proper financial planning can assure retiring owners a steady stream of income to support their lifestyle and plans, and a well thought out succession blueprint can ease the stress of their departure and leave their business in good hands.

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