Today, many professional firms have a sobering problem when it comes to older partners. It can be difficult enough to negotiate a sale of an ownerâs interest, and finding a way to pay for it is an even greater challenge.
A unique retirement plan variation can grease the skids of an exit strategy and leave all parties in a win-win situation. It involves the creative use of a special retirement hybrid known as a cash-balance plan. In a partnership buy-out, a cash-balance plan can be incorporated as an overlay to an existing 401(k) plan and create the opportunity for massive retirement plan contributions for older people in their 60s - and by massive, I mean something in the neighborhood of $150,000 per year for business owners approaching retirement.
The typical dilemma for younger owners stems from their need to come up with after-tax dollars to buy out a retiring partner. This means a payment of $500,000 will cost $1 million in pre-tax dollars. Then, the dollars are taxed at capital gains rates to the departing partner who, if a founder of the business, probably has a cost basis of zero. Therefore, the entire amount of the sale proceeds will be taxed at capital gains rates. In simple terms, over half of all the money required at the start of the transaction will be paid in taxes by a combination of the buyer and seller.
The beauty of incorporating a cash-balance plan into the mix is that the contributions are a tax-deductible expense for the firm and its remaining younger business owners. For the seller, the deposits are tax-free - or at least tax-deferred - until the retiring seller starts spending the money years later in retirement. Moreover, the money in the plan can be invested and compounding on a tax-deferred basis over the years.
A CASE STUDY
In an example of a small firm with an owner and a handful of employees, we start by calculating a yearly "service credit" for each year the firm's owner has worked. In an actual recent case, this turned out to be $25,000 a year for the 25 years this professional had been self-employed, so a total of $600,000 becomes the "opening balance."
Since he wants to retire in five years, we extend the $25,000 annual service credit out for that length of time compounded at 6 percent per year. We also compound the $600,000 opening balance out for five more years at 6 percent. The total of the two numbers is just under $1million.
Now, we work backwards to determine how much money has to be contributed over the next five years to accumulate the $1 million lump-sum funding level we have just calculated. An annual tax-deductible contribution of $175,000 earning 6 percent for the next five years will do the trick. Fortunately, with the business (at least) in its prime of life, this owner could afford to make those tax-deductible contributions.
Meanwhile, what about other employees in this small firm?
Well, typical turnover at small firms generally means that not many folks have worked long enough to have accumulated much in the way of an "opening balance." This reduces the lump sum to be funded for them. Also, their younger ages as a group allow us to use a much lower service credit. The service credit for the business owner was 12.5 percent of current salary. The other employees had a 2 percent of current salary service credit, because hypothetically they had the advantage of about 30 years until retirement. This meant that the business owner contributed about $15,000 for a handful of younger employees as a cost for the right to contribute $175,000 into his own account. A further advantage is that each employee has their own specific account. They can actually see their money, as opposed to just a vague promise of an "accrued benefit" that may or may not be adequately funded.
The cash-balance plan, in this small company environment, offers a tremendous advantage for older business owners or professionals. This example was extreme, to illustrate the point, but this vehicle can be can be incorporated as an overlay to existing 401(k) plans to "supercharge" the contribution levels and accomplish more for senior owner/employees who find themselves behind the retirement eight-ball. Employers view their contributions for employees (required for only the lowest-paid half of the non-owner employees) as a good bargain. The thought process says, "I'm just giving to my associates a portion of what I otherwise would have paid in taxes."
ALIGNING PRIORITIES
The example above is small and simple to illustrate the mechanism. In the case where the tool is used to fund the business interest buyout of a senior partner, younger partners are treating the substantial retirement plan contribution as installment payments for their ownership interest.
People selling business interests later in life too often assume the value of their stock amounts to what they have calculated as that final nut to fund their retirement lifestyle - and the sales price in their mind's eye has been "grossed up" to cover the estimated capital gains tax on the sales proceeds. Either that or the sellers have some round number in their heads like "$1 million." The nicest people in the world can rationalize what's in their self-interest.
Potential buyers, of course, only care about what the business can support financially and still be a going concern. Emotional benchmarks mean little or nothing, and this disparity in priorities can bring negotiations to a standstill.
Judicious use of the cash-balance plan - before it gets too late - begins the process of eating the elephant one bite at a time. Practiced over a number of years as part of the sales process, it relieves the pressure of having to come to terms with a single, final, large number.
Steve Butler is the founder and president of Pension Dynamics Corp. (www.pensiondynamics.com), a retirement plan consulting and administration company. Reach him at sbutler@pensiondynamics.com.
