A skit on vintage Saturday Night Live episodes depicts a couple who insist on staying as dinner guests for an unreasonably long time after a party. In their hilarious efforts to prolong an evening of inebriation, they became known as "The Thing That Wouldn't Leave."
Today, many businesses -- especially professional firms -- have a sobering problem when it comes to older partners. It can be difficult enough to negotiate a sale of an owner's interest, and finding a way to pay for it is an even greater challenge.
The whole subject can be awkward to broach, and even in the best of circumstances there is potential for acrimony. After all, we all know by now that when someone says, "This is not about money," it's about money.
A unique retirement plan tool can grease the skids of an exit strategy and leave all parties in a win-win situation. This would involve the creative use of a special retirement hybrid known as a cash balance plan.
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 -- something in the neighborhood of $150,000 per year -- for people in their 50s or 60s.
The typical dilemma for younger 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 million in pretax 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 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 will compound on a tax-deferred basis over the years until spent.
How does a plan work?
We start by calculating a yearly "service credit" for each year the company 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 -- a total of $600,000 becomes the "opening balance" (another way of saying that this is what he should have had by now if he had started saving years ago.)
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 $1 million.
Now, we work backwards to determine how much money has to be contributed over the next five years in order 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.
The remaining partners are happy to allocate corporate resources for this purpose with the understanding that the value of the firm will be based on its very low book value when the actual sale takes place.
Meanwhile, what about other employees in this small company?
A typical turnover at small companies 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 service credit of 2 percent of current salary because, hypothetically, they had the advantage of about 30 years until retirement.
This meant that in this example of a 20-person company, the business owners contributed about an annual $15,000 for a handful of younger employees as a cost for the right to contribute $175,000 into the departing partner's account for each of the next five years.
Considering the tax savings, it's a stupendous benefit for all parties.
Sellers of a business interest often have some round number in their heads like $1 million. If not for ego purposes, the number is based on what someone feels they need to complete their retirement nest egg. Unreasonable emotional benchmarks on both sides 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 few years before the ultimate sale, it relieves the pressure of having to come to terms with a final large number or, worse yet, becoming "The Thing That Wouldn't Leave."