The traditional methods of funding retirement obligations and life and disability insurance payments create tax inefficiencies and significant risks. Buyout payments to retiring owners are nondeductible to the firm or successor principals. Moreover, the retiree is subject to capital gains taxes on the payments and any residual value is subject to estate taxes when assets transfer to the next generation. Life and disability insurance premiums are typically paid with after-tax dollars, creating additional costs to the firm, which does not receive the benefit of a tax deduction for the payments.

Due to these tax inefficiencies, most firms utilize some form of nonqualified deferred compensation plan to provide the promised benefits to retiring owners. In effect, the firm converts most of its previously nondeductible obligation into tax-deductible payments that are also taxed as ordinary income to the retiring partner. Funded or unfunded arrangements are typically chosen to cover retirement benefits, whereas insurance is usually chosen to cover disability and death benefits. The retirement benefits, funded or unfunded, are almost always provided for in nonqualified plans, with provisions set forth in the firm’s partnership agreement (or a separate agreement if the firm operates as a corporation). All benefits of unfunded arrangements are financed with the postretirement earnings of the firm. This places a heavy burden on the remaining owners for funding and subjects the retiring owner’s benefits to the firm’s future. In funded arrangements, actuarially sound payments are rare; ad hoc funding methods, usually limited by current cash flow considerations, are the norm. Furthermore, any funding is not tax deductible, and the growth, even if set aside from other firm assets, remains taxable. Both prefunded amounts and current payments are subject to firm creditors.

Insurance funding is also not tax deductible and is frequently insufficient to cover the benefits promised. The retiree assumes the risk of receiving less than the full promised payout while receiving payments subject to ordinary income tax rates and exposing the residual value to depletion from estate taxes.

A Better Solution

Through advance planning, qualified pension plans can enable firms to set aside capital to help prefund retirement benefits payable under the existing nonqualified plans, thereby reducing or entirely eliminating any unfunded retirement obligations. Such an approach permits the prefunding of retirement benefits with pretax dollars and protects the funds from creditors. The following summary illustrates how these funding arrangements can be created by using existing qualified plans, with little or no additional employee costs:

1) Restructure the qualified plan to offset the nonqualified plan obligation. The firm’s goal is to prefund retirement benefits within a qualified retirement plan. Prior to any restructuring, most qualified plans, even those integrating with Social Security, provide owners with significantly less value than nonowners in terms of projected retirement benefits as a percentage of projected final pay. Traditional plan designs are uncomplicated, typically funding a flat percentage of pay to each covered employee, and, at best, recognizing the employer’s contribution toward Social Security in the allocation formula. Because owners are generally closer to retirement age than most employees, their benefit will generally be less as a percentage of their pay at retirement because of the shorter accumulation time horizon. With proper plan design, it is usually possible to restructure a qualified plan so as much as 85% or more of the total plan contributions benefit the owners. Without affecting the amount spent for employees, larger contributions can now be allocated to the owners. The increase in qualified plan benefits may significantly offset, or even eliminate, any unfunded retirement liabilities. Most importantly, this result is achieved with pretax contributions, allowing the plan assets to grow on a tax-deferred basis for the retiring owners’ benefit, further offsetting the firm’s nonqualified plan obligation to retirees. Finally, because qualified plan assets, with certain exceptions, should not be subject to creditors, the prefunding of the obligation in this way substantially frees the exit strategy from exposure to the firm’s creditors.

In essence, this approach enables substantial asset accrual through a prefunded qualified plan, maximum tax efficiency, and substantially reduced creditor risk. Additionally, the reduction or elimination of the nonqualified plan retirement obligation lessens the potential pressure on the cash flows and lifestyles of those remaining. When you add that frequently all this can be achieved with little or no additional cost for employee benefits, it is an excellent alternative.

Case Study. A firm with 14 partners and 80 employees had a 401(k) plan and a nonqualified plan program funded at a level of $150,000 per year on a nonqualified basis. Since this plan was not tax deductible, the real cost to the firm was $300,000 per year. The partners agreed that if they could design a qualified plan with at least 80% of the contributions for the owners and restructure their after-tax life insurance plan to a pretax plan that they would be able to afford a contribution of about $400,000 a year to a tax-deductible qualified plan that would reduce their existing nonqualified retirement plan obligations and purchase life insurance.

Due to the composition of the work force, a two-plan approach (see the Sidebar) worked best. One of the complexities facing the firm was the method of allocating the owner funding. The firm developed a detailed worksheet tying its current obligations to ownership interests. Analyses using several different funding strategies, a variety of present value assumptions, and allocating contributions on the basis of owner K-1 income aided the choice of a final strategy. Since the models employing present value of benefits sometimes skewed the cost allocation toward senior partners, which was not the intended objective, it was decided to allocate owner funding based on each owner’s percentage of partnership income.

This arrangement covered all owners in a defined benefit plan along with nonprofessional employee groups, with the balance of employee groups (professional nonowners) in a defined contribution plan. Contributions were developed within the firm’s guidelines, including obtaining the life insurance policies on a tax-deductible basis inside the pension plan. The owners’ share of the total contribution was in excess of 80%. The total qualified plan contribution was $400,000 per year: $335,000 allocated to partners and $65,000 to employees. A small percentage of the partners’ $335,000 share was utilized to purchase life insurance on a before tax dollar basis, which funded their exit strategy in case death occurred prior to retirement. They also now had $335,000 a year on a tax-deferred basis, plus tax-deferred growth, available to offset partners’ nonqualified retirement plans. With few exceptions, none of these dollars is subject to claims by firm creditors.

2) Allocate plan contributions and adjust incomes. Because older partners generally have a shorter accumulation time horizon, most qualified plans will allocate a larger portion of the contribution to them (partnership agreements or other governing documents may require amendment to reflect these requirements). Two common income allocation bases to adjust for qualified plan contributions are—

The most common design allocates the necessary contributions to fund the senior partners’ retirement benefits over the personal incomes of the other partners or shareholders: The retiring partner’s contribution in the tax-deductible qualified plan offsets the retirement benefits, thereby reducing the other partners’ postretirement obligation to them. If the total qualified plan contribution is $100,000, and Partner A’s share is $15,000, this $15,000 is allocated to all other partners in proportion to their partnership income shares. Fortunately, the impact on partner income is minimized by the tax deductibility of the contributions.

For example, if partner contributions are increased by $100,000 to a tax-deductible qualified plan (assuming the 50% income tax rate), then $50,000 of income taxes is saved, and all partners’ cumulative net income is reduced by $50,000. There is now $100,000 in the qualified plan along with tax-deferred earnings to offset all partners’ nonqualified plans. When you compound this over a period of years, it can offset a great percentage of retirement benefits in the partnership agreement (or a separate nonqualified plan agreement, if the firm operates as a corporation). Again, with few exceptions, all of the prefunding into the qualified plan is not subject to creditors.

3) Purchase life insurance in the qualified plan. By placing life insurance inside the qualified plan, the pretax earnings required to pay premiums are reduced by approximately 50%, with the difference available to contribute to the qualified plans in prefunding of the nonqualified plan. This increases the available dollars toward funding the nonqualified plan arrangements and lessens the likelihood that some benefits for retiring partners will remain unfunded.

In the case discussed above, annual insurance premiums of $60,000 were being paid on an after-tax basis, with a real cost of $120,000. By folding the death benefit needs into the qualified plan, these costs were converted to deductible dollars, and the overall budget to prefund the nonqualified plan benefit obligations was increased by $60,000. All this was accomplished without any reduction of personal income to the partners.

Some firms will even modify their governing documents to require an assignment of a life insurance policy equal to at least 60% of the firm’s liability when an owner exits for any reason other than death. Since payments under a nonqualified plan are tax deductible (as they are paid out as ordinary income upon a partner’s retirement), the insurance benefits assigned to the firm provide for significant cost recovery (as insurance proceeds are received income tax–free). Many firms maintain the insurance policy beyond the partner’s retirement date, guaranteeing the cost recovery of the nonqualified plans, even if the date of death is after some or all of the partner’s benefits have been paid out. Therefore, these proceeds not only provide the firm with great value to offset costs but also are a good source for funding future obligations.

Challenges to Plan Design

Designing a qualified plan to fund all of the owners’ objectives on a tax-favored basis requires answering several questions:

Information necessary to determine the feasibility of funding the exit strategy on a tax-deductible, tax-deferred basis by using one or more qualified plans includes the following: