I had a great meeting with one of my long-time small business clients last week. The client is a family business established many years ago by Mom and Dad and is currently in a transition period. Mom and Dad are in their seventies and their two sons are beginning to take over daily operations of the company. All four family members are stockholders. The meeting was with the four to discuss the current fiscal year-end.
One topic that came up concerned Dad’s ability to continue to receive income from the company. He is looking ahead at either fully retiring or substantially stepping away from daily operations. Dad, who I will refer to as Jerry, has been contributing to the company’s retirement plan. But he is concerned that distributions from the plan will not be adequate for his retirement. More importantly, he wants to receive an income stream from the company for all of his years of sacrifice and hard work. Jerry wants a company pension.
Most Small Business Owners Fail to Save for Retirement
A recent Washington Post article, Are small business owners too busy to think about saving for retirement?, addressed the retirement issue for small business owners. Turns out, small business owners are not any better at saving for retirement than their employees. The article details statistics from a recent BMO Wealth Management survey.
According to the survey, 75% of the nation’s 28 million small business owners have less than $100,000 saved for retirement. As Jason Miller, head of wealth planning at BMO, said, “Preparation and pre-planning is key. It’s easy for momentum to take over. Slow down, step aside and put together a plan for contingency and business succession.”
What Can Jerry Do
In Jerry’s case, he has a few options to consider that can be implemented now despite the late start. These options can be applied to many different situations.
Company pays off shareholder payables
Through the years, Jerry and his wife have made various cash loans to the company to fund operations. All loans have been adequately documented and payments have been made on the loans. Furthermore, the loans have been consistently reported as shareholder payables on the company’s tax return.
For Jerry, repayment of these loans provides a partially tax-free stream of cash flow. Only the interest from the loan payments is taxable income to Jerry. However, that also means that only the interest expense is deductible to the company. The principle portion of any payment on the shareholder payables must be repaid with after-tax dollars. For instance, if the company breaks even for the year and makes $30,000 in principle payments on these loans, then theoretically the company will have $30,000 less cash in the bank than the previous year.
The company should go ahead and increase the loan payments. Loan documentation should be updated for the increased loan payment and the interest rate on the loan should be decreased down to the current rates, which remain at historic lows. The updated loan documentation should detail the interest rate, the frequency of payment, and the amount of the payment.
Jerry sells his company stock
Another option for Jerry is to sell his company stock to either his sons or the company. Jerry could sell his stock on an installment plan, ensuring a steady stream of income for an extended period of time. Like payments on the shareholder payables, this installment would generate interest income to Jerry. Unlike the payments on the shareholder payables, the principle payment may also be taxable. The sale would generate capital gain income to Jerry if the sales price of the stock is greater than his stock basis. (Losses would be nondeductible to Jerry if the stock is sold to a related party.) So, this option is costlier to Jerry than the repayment of the shareholder loans.
From the buyer’s perspective, the stock purchase creates another nondeductible cash outflow. With the company already committed to repaying the stockholder loans, this was not a viable option for Jerry’s company at this time.
Set-up a nonqualified deferred compensation plan
Jerry and his company have another option. His company could set up a nonqualified deferred compensation plan. Unlike qualified deferred compensation plans, such as the company’s 401(k) plan, a nonqualified plan is not subject to anti-discrimination rules and other requirements. Because of this, nonqualified plans can be targeted to a specific group of employees, such as officers and owners.
A nonqualified deferred compensation plan would be an arrangement between Jerry and his company to defer a portion of his current year income to a set time in the future. The company does not deduct the compensation until he receives and recognizes the income based on the timetable outlined in the plan. Money does not have to be set aside for the plan, but payroll taxes have to be paid on amounts elected to be deferred. Because of the payroll tax requirement, it generally works best when Jerry’s salary is over the Social Security wage base. That way, Jerry only pays Medicare taxes on the deferred compensation.
The advantage to Jerry is that a nonqualified deferred compensation plan will defer the income taxes on the compensation from the time it is earned until the time it is paid to him. A plan for Jerry could be structured to begin payments once the shareholder payables are fully paid out. This could stretch Jerry’s cash flow for many years beyond the payment of the shareholder loan. We will be exploring this option with Jerry over the next few months.
More information about nonqualified deferred compensation plans can be found on my firm’s website: Know the tax rules for nonqualified deferred compensation plans.
Hedge Your Bets
All small business owners need to consider their retirement income. I have often told clients to establish a company retirement plan early and contribute as much as possible while still maintaining a healthy company. Early on, you may plan on selling your company to fund your retirement. By contributing to a retirement plan, you are hedging a loss in the future value of your company, either due to market conditions or your desire to sell the company at a substantial discount to the next generation.
Also, please remember that these options all require proper documentation. This article is meant to introduce you to options that may or may not be good for your situation. Please consult your financial and legal advisers before implementation of any of these options.