Ensuring Smooth Succession and Retirement

By Ed Bowen and Gary Charles

In Brief

Using Defined Benefit and General Partnership Plans

Wealth accumulation through retirement plans and business succession planning before retirement are frequent concerns for business owners. The authors identify strategies that can provide business owners with attractive alternatives when addressing these issues. The 412(i) “fully insured” defined benefit plan offers simplicity, maximum current tax-deductible contributions, and guaranteed retirement benefits. It allows for greater contributions and is exempt from certain funding requirements of other IRC section 412 plans. Business succession for the closely held business can be greatly facilitated through the use of complete business valuation and buy-sell agreements. Stock redemption, cross purchase, and general partnership plans are forms these agreements can take, and the latter can eliminate the disadvantages inherent in the previous two.

According to the Wilshire Associates 2003 Corporate Funding Survey on Pensions, defined benefit pension plan assets for the 320 S&P 500 companies that have them dropped by $106 billion to $892 billion, while liabilities for those same plans increased from $105 billion to $1.07 trillion. The report also states that almost nine out of 10 corporate pension plans are now underfunded.

With all the recent negative press regarding such underfunding, why do some believe that defined benefit plans are coming back into favor? Wouldn’t it be prudent to learn from past mistakes and look in a different direction when setting up business retirement plans? Many business owners have been looking in such a direction, specifically the defined contribution market, with 401(k)s becoming the dominant plan design. A January 2002 article in the St. Louis Federal Reserve Bank Review states that the period from 1983 to 1995 witnessed a 19% increase in workers holding defined contribution plans, while there was a 45% decrease in those with defined benefit plans. So why would defined benefit plans make a comeback? First, what is fueling this reemergence? More important, who is setting up these new defined benefit plans?

The Reemergence of Defined Benefit Plans

A number of favorable tax law changes have provided the fuel for defined benefit plan growth. Congress recently lifted the contribution limits under IRC section 415(e), which had restricted the total amount of tax-deferred contributions and defined benefit plan accruals for any particular participant, if the sponsor offered both defined contribution and defined benefit plans. As a result, it is now possible for business owners to contribute and fully deduct contributions to both plan types in the same year. In 1999, Congress raised the annual limit on the ultimate benefit for a defined benefit plan to a maximum of $160,000.

The consensus opinion seems to be that the baby boom generation has done a poor job of saving for retirement. This contention is not without some controversy. Some pessimistic reports indicate that boomers save only a fraction of what they need in order to maintain their preretirement standard of living. Some optimistic reports contend that boomers will be substantially better off in retirement than their parents. Regardless of which view ultimately prevails, retirement saving has taken a back seat to other financial needs for many boomers; they have been putting their children through school, starting and building their own successful small businesses, and supporting their parents in retirement. These same individuals are now looking for a way to catch up in their retirement savings, and many are small business owners that do not have access to a company’s 401(k). This is the group for which defined benefit plans will provide the maximum benefit. They have the immediate need to save a lot of money in a relatively short period of time, and many also have the available cash to commit to this approach.

“Among small business owners, there has been a resurgence of the defined benefit plan,” says Linn Christensen, president of Benefit Plans of Omaha, a third-party administrator of plans for companies with fewer than 300 employees. “We’re seeing baby boomers hitting their 50s and, if they haven’t done much for retirement planning, then they are looking at plans such as defined benefit plans that allow them to put away a lot more money,” says Christensen. Defined benefit plans allow these individuals to contribute and deduct amounts in excess of $100,000 per year, as opposed to the defined contribution maximum of $40,000 per year. Additionally, for certain business owners, an IRC section 412(i) “fully insured” defined benefit plan could allow for a 50% to 70% higher deductible contribution than would a traditional plan (see Exhibit 1).

Using an IRC Section 412(i) Plan

IRC section 412(i) provides an exemption from the complex funding rules laid out in the rest of IRC section 412, which apply to all other defined benefit plans. Funding for these plans is generated exclusively from life insurance and annuity contracts.

Fully insured IRC section 412(i) plans provide attractive alternative solutions to more traditional defined benefit plans. (See Exhibit 2 for a discussion of which individuals make good candidates for defined benefit plans.) The plans offer simplicity, maximum current tax-deductible contributions, and guaranteed retirement benefits. The accrued benefit for participants is the cash surrender value of all insurance contracts. It allows a maximum current tax-deductible contribution for the business, given the inherent low internal rate of return of the insurance contracts. A 412(i) plan also minimizes risk; the third-party insurer guarantees all benefits, assuming premiums are paid when due, thus minimizing the employer’s investment risks. Plan sponsors are currently looking for conservative solutions; the pendulum is swinging away from the optimistic mindset of the mid to late ’90s, toward more cautious thinking that emphasizes certainty and guarantees.

The 412(i) plan will provide for large current tax deductions and conservative growth, while providing a comfortable future retirement. Caution should be exercised, however, when looking for plan vendors, as some providers think they must make the tax and economic advantages of 412(i) plans more attractive in order to compete for business.

Business owners should be wary of abusive 412(i) schemes, which are typically predicated on limited payment of premiums, followed by plan termination and rolling out the insurance while it has a low cash value (via high surrender charges). The IRS considers abusive 412(i) schemes to be an issue of paramount importance. Speaking on aggressive tax practices at the annual Los Angeles Society of Pension Actuaries, Richard J. Wickersham, manager of TE/GE guidance and quality assurance, warned that the IRS will “not be gentle” during retroactive examinations of illegal section 412(i) schemes. “No one should take comfort in the fact that there is no guidance yet,” said Wickersham, who also reminded the conference attendees that “there is a criminal side” to such schemes that goes beyond simple tax penalties or fines.

Business Succession with a General Partnership Plan

For many high-net-worth individuals that are closely held business owners, business succession planning can be overwhelming. Often, the issue is pushed aside until it is too late, or planning is incomplete and not properly implemented. Either way, great difficulties can arise for the business owner’s heirs, as well as for the business itself.

When contemplating the sale of a business interest, there are important questions that a business owner must answer:

A complete business valuation and buy-sell agreement can provide effective answers. A properly executed buy-sell agreement achieves the following goals:

Once the commitment is made to enter into a buy-sell agreement, the type of format must be determined. Stock redemption and cross-purchase plans have been the most widely utilized formats, and a third option is the general partnership plan.

Stock redemption plans. A stock redemption plan is an agreement between a corporation and its shareholders whereby the corporation purchases the owners’ shares upon a triggering event such as death, disability, or retirement. The employer is the owner and beneficiary of policies on the lives of the shareholders. The corporation uses insurance proceeds to purchase the shares of the deceased owner.

Stock redemption plans are easy to establish and administer, and their insurance funding requires only one policy type per owner. The corporation can also absorb unequal insurance costs due to age or health differences among the owners. Such plans also have some shortcomings: The surviving shareholders receive no step-up in cost basis on redeemed shares, and insurance funding may be subject to the alternative minimum tax. Furthermore, insurance policies owned by the corporation are subject to creditors’ claims.

Cross-purchase plans. A cross-purchase plan is an agreement between corporate shareholders in which surviving owners purchase a deceased shareholder’s stock on a pro rata basis. Each owner purchases insurance on the lives of the other owners, and any proceeds the surviving owners receive are used to purchase the shares of stock.

On the positive side, cross-purchase plan shares purchased by surviving owners receive a step-up in cost basis, and insurance owned by shareholders is not subject to the alternative minimum tax. In addition, insurance funding is not subject to the claims of corporate creditors. On the negative side, insurance funding requires that each owner hold multiple policies, premium inequities may result from age and health differences, and attempts to transfer insurance funding to a retiring owner may result in a taxable gain.

General partnership plans. A third option available to corporations can capture the advantages of both stock redemption and cross-purchase plans while eliminating their disadvantages: the buy-sell plan utilizing a general partnership.

A general partnership is established to hold the insurance policies on the owners’ lives. The shareholders are also general partners in the partnership and agree to obligate the partnership to purchase their interests upon a triggering event such as death, disability, or retirement. They also enter into a “wait and see” buy-sell agreement that allows the parties to choose between a stock redemption and cross-purchase format at a future date. Under this method, the corporation has the ultimate responsibility to purchase the shares if the surviving owners decline the option. After a qualified triggering event, insurance proceeds flow into the partnership. The partnership purchases the deceased partner’s interest and then distributes the balance of the insurance proceeds to the surviving partners, and these monies are then used to complete the buy-sell agreement.

This unique plan design offers the following advantages:

There are issues to be considered, however, before adopting this format. Companies should anticipate additional costs necessary to draft the general partnership documents, prepare tax returns on the partners, and administer the partnership. This plan design can be very attractive under the right circumstances because of the unique tax advantages afforded to general partnerships, and it provides closely held business owners with another business succession planning tool.

Ed Bowen, CLU, ChFC, is manager of 1st Global’s Advanced Case Design Group, which handles high-net-worth clients. Gary Charles is
the retirement planning director for 1st Global, Dallas, Texas (www.1stGlobal.com).

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