One of the main reasons that older business owners are reluctant to give up control of their companies is that they don’t want to ever have to ask their children for financial help.
If you are thinking of transferring control of your company to your children and have a similar concern, you might consider establishing an income continuation plan. To illustrate how such a plan works — and its advantages — let me tell you about a good client of mine, Mr. C, who is weighing this option.
Mr. C is in the process of passing his corporate culture, goodwill, and ownership to his son and a key executive — both of whom are quite competent. Due to the efforts of all of the parties involved, the company is thriving and growing in value. Despite a fairly aggressive gifting program, Mr. C still owns approximately 60 percent of the company stock. He would like to gradually reduce his involvement in the firm so that in seven or eight years, when he will be 70, he can retire completely. The firm’s qualified retirement plan is primarily for the benefit of the rank-and-file employees and will not provide Mr. C with as much income as he feels he needs to comfortably retire.
As is true of many successful entrepreneurs, much of his financial worth and most of his psychic worth are tied up in the business. In the past, the gifting has been fun for Mr. C. He has enjoyed sitting down with his designated successors and advisors to value the company and to make his gifts. This year, however, he feels a little older and, as his share of ownership moves closer to the magic 50 percent mark, it’s not quite as much fun. What can he do?
Of the potential solutions, one of Mr. C’s best choices is an income continuation plan. Basically, the plan is a written agreement between a company and an executive in which certain rights and obligations are spelled out. In big public companies these plans are called SERPs (supplemental executive retirement plans). In the closely held company, the payments called for in the agreement must be “reasonable” when compared with the owner’s past and anticipated future earnings together with all other forms of compensation from the company such as car and housing allowances. If it is not reasonable, the IRS will likely claim that the company has paid a dividend to the owner and therefore cannot deduct it from taxes.
Mr. C and his company can enter into an employment agreement under which he will be employed at no less than his current compensation — about $100,000 — until be reaches age 70. When he retires at that age, he will begin receiving $60,000 a year for as long as he lives and, if he dies before his wife, she will receive the payments for the balance of her life. If he dies prior to age 70, his spouse will receive a lump sum (the amount is specified in another agreement) from an employer-funded life insurance benefit. If he is disabled before age 70, he will start receiving his $60,000 a year at that point; and he and his wife will be entitled to the benefit for as long as either lives.
Now some business owners may ask why all this is necessary; you may feel that you and your successors can simply wait until you reach retirement, and then they can just keep paying your salary. Many owners have done that or are doing it now for their parents.
This seemingly simple approach brings with it significant income, FICA, and succession tax risks. More important, you’re not going to know if you’re wrong until it’s too late to correct the situation. The retired owner’s salary may not be picked up in a tax audit ‘ But when he dies, any payments of the salary to the spouse would almost certainly be discovered and considered dividends that cannot be deducted by the company.
Let’s look at the potential tax advantages of an income continuation plan:
Income Taxes. As noted earlier, if the compensation is “reasonable” when the plan is established, the company can deduct payments to the retiree from its income taxes. Generally, when trying to decide what is reasonable, the IRS considers such things as length of past service; number of years to retirement; current and past compensation; current and past company profitability, and so on.
The payments must, of course, be included for tax purposes in the income of the retired executive. Since the payments are not related to stock ownership, however, the owner doesn’t have to be concerned about disguised dividends.
FICA. As most employers are painfully aware, payroll taxes are growing more rapidly than income taxes. Neither employer nor former employee is subject to FICA taxes on benefits paid by reason of retirement, however. Also, if the executive retires before age 70, there is no earned income offset against his Social Security benefits.
Estate and Inheritance Taxes. If an executive dies leaving his spouse a benefit that will be paid to her only for as long as she lives, there will be no estate tax on that benefit since it goes to his spouse and disappears when she dies, leaving nothing to be passed or taxed.
Besides the possible tax advantages, Mr. C may feel a little more comfortable giving up control of his company when he knows he has a contractual relationship with the business to continue his income. Nevertheless, under the income continuation plan, Mr. C becomes dependent to some extent upon his successors to continue his flow of income; he has moved from being an owner to being a general creditor.
Every planning device has its tradeoffs. This is just another example of the TINSFAAFL Theory — There Is No Such Thing As a Free Lunch.
Under the income continuation plan, the owner trades some degree of security for substantial tax savings. From a practical point of view, Mr. C must face the fact that he will eventually have to rely on someone else to run the business, even if he retains full control. If he does not come up with a succession plan that satisfies his son and key executive, they will not stay around to provide him with the security he seeks.
An income continuation plan can be a useful tool in the right situation. The expense and risk of such a plan is relatively small compared with the increased comfort and security it offers aging business owners.
David J. Downey is president of Downey Planning Services Ltd. of Champaign, Illinois, which specializes in wealth creation and preservation for owners and executives of family businesses.