Article of the Week
“The Beauty of a Cash Balance Buy-Out Tool”
by Stephen J. Butler
Today, many businesses - including professional firms such as law practices - have a sobering problem when it comes to retiring partners. It can be difficult enough to negotiate the sale of an owner's interest, but finding a way to pay for it is an even greater challenge.
A unique retirement plan variation, known as a cash balance plan, can grease the skids of an exit strategy and leave all parties in a win-win situation. As part of 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 people in their 60s. In this context, "massive" can mean something in the neighborhood of $150,000 per year for many business owners approaching retirement.
The typical dilemma for owners of a professional practice stems from their need to come up with after-tax dollars to buy out a retiring partner. This means that a payment of $500,000 will cost $1,000,000 in pre-tax dollars. Then, the dollars are taxed at capital gains rates to the departing partner who, if an original 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 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 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, compounding on a tax-deferred basis over the years.
In an actual 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 a recent case, this turned out to be $25,000 a year for the 25 years this professional had been self-employed --- a total of $600,000 becomes the "opening balance." ("Opening balance" is another way of saying that this is what he should have by now if he had started saving years ago.) Since the owner wants to retire in five years, we extend the $25,000 annual service credit out for that length of time compounded at 6% per year. We also compound the $600,000 opening balance out for five more years at 6%. The total of the two numbers is just under $1,000,000.
Working backwards, we then determine how much money has to be contributed over the next five years to accumulate the $1,000,000 lump sum funding level we have just calculated. An annual tax-deductible contribution of $175,000 earning 6% for the next five years will do the trick. Fortunately, in this particular case, the owner could afford to make those tax-deductible contributions.
Meanwhile, what about other employees in this small firm? With turnover typical for a small firm, few employees had accumulated much in the way of an "opening balance." This reduces the lump sum to be funded for them. Also, their relatively young age as a group also allowed us to use a much lower service credit. The service credit for the business owner was 12.5% of the current salary. The other employees had a 2% of current salary service credit, because hypothetically, they had the advantage of about thirty years until retirement. This meant that the business owner contributed about $15,000 for a small number of employees as a cost for the right to contribute $175,000 into his own account. As a further advantage, employees received their own individual accounts, allowing them to actually see their money as opposed to having to rely on 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 business owners or professionals contemplating retirement. The same vehicle can be can be incorporated as an overlay to existing 401(k) plans to "supercharge" the contribution levels and accomplish more for senior owners/employees who find themselves "behind the retirement eight-ball." Employers view their contributions for employees (required of only the lowest-paid half of the non-owner employees) as a good bargain. "After all," employers might reason, "I'm just giving to my associates a portion of what I otherwise would have paid in taxes."
In the case where the cash balance plan tool is used to fund the business interest buy-out of a senior partner, younger partners are treating the substantial retirement plan contribution as installment payments for the senior partner's ownership interest.
People selling business interests later in life too often assume the value of their stock amounts to that final nut that will fund their retirement lifestyle - and in their minds, the sales price 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 "One million dollars." Buyers, of course, only care about what the business can support financially. 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 is 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 Corporation, a retirement plan consulting and administration company, in business since 1980. He can be contacted at firstname.lastname@example.org or http://www.pensiondynamics.com.