Retirement strategies for the family business owner
Which type of business owner are you? 1. “I plan to stay at the helm of my business until I drop,” or 2. “I’ll work hard now, so I can enjoy life in retirement.”
If you identify with either of these, you know where you stand. Many business owners, however, have difficulty thinking about long-range planning, especially given a business’ complexities.
Often, the daily work “in the business” is so consuming, it feels impossible to step back and imagine retirement. Only working “on the business” and long-term planning can make a goal of retirement a reality. What follows are some strategies you can consider if you are a Type 2 family business owner.
In 2016, the best place to start is with an examination of your form of business organization. Most small businesses began as a sole proprietorship, a partnership, S Corporation or LLC taxed as a partnership. The common thread: all profits and losses flow through to the individual owners with net profits taxed at individual income tax rates; no income tax exists at the business level. When individual income tax rates were less than corporate tax rates, using a “flow-through” business entity made sense, especially in early years, when losses played a larger part in overall tax planning.
Federal income tax law changes starting in 2013 have impacted planning dynamics. Now, marginal rates for top earners are significantly higher than the corporate rate. Further, an election to be taxed as a C Corporation allows the deduction of more benefits, many of which can significantly aid retirement planning.
For example, Jane and Jack are siblings who co-own a real estate S Corporation. They each earn a salary of $300,000; taxable K1 profits are $2.5 million, making each shareholder liable for tax on $1,550,000. Personal married filing joint tax rates, social security and Medicare withholding produce a tax of about $555,615, or an average of 36.9 percent.
If their company instead had been a C Corporation, income, social security and Medicare tax on the salaries would have been about $74,044, or an average tax rate of 24.68 percent. Their corporation would pay about $770,100 in corporate tax on the profits but allocated individually is half that — $385,050. Total effect to each shareholder is $459,094. The C Corporation structure would have left about $195,043 more in the owners’ personal and business pockets.
This example is very simplistic; its sole purpose demonstrates the effect of a C Corporation election in a limited set of circumstances. Your CPA can do a more exact analysis for your business to help you determine whether it makes sense for your company to abandon flow-through taxation.
Fringe benefits are treated more favorably when the entity is a C Corporation. Health insurance, including long-term care insurance, is deductible by the flow-through business, but premiums attributed to a greater-than two-percent owner constitute wages to that owner. In a C Corporation, premiums for the owner don’t increase wages. Owners who are able to use deductible dollars to fully pay for long-term care insurance prior to retirement position themselves with greater protection of personal assets during retirement should an illness occur requiring long-term care.
A robust retirement planning benefit available to owners and executives, with greatest tax benefits to those employed by C Corporations, is nonqualified deferred compensation (NQDC). NQDC is a plan promising a highly compensated executive/owner the business will pay an income at a later point in time, generally retirement. NQDC can be structured to allow deferral of current salary, bonus or a combination. Current tax applicable is only FICA, FUTA and Medicare; no income tax is due until funds are distributed. For a business owner with earnings above the social security wage base ($118,500 in 2016), amounts deferred are exempt from FICA and FUTA.
Since federal top marginal tax rates are 39.6 percent, and additional Medicare tax and net investment income tax is due for those whose adjusted gross income exceeds about $250,000, the deferral of income to below that may potentially save thousands prior to retirement.
NQDC plans are not “funded” as qualified pension plans are, and the substantial risk of forfeiture gives rise to the deferral of income tax with NQDC. Many businesses with these plans “informally fund” the plan with annual contributions to a business-owned portfolio of life insurance, which remains subject to the business’s general creditors. Funds from the policies may be tapped to pay future benefits, with death benefits to help the business recover the costs of the plan. NQDC can take advantage of arbitrage between personal and corporate tax brackets.
Family businesses of any type may benefit from a well-structured qualified pension or profit-sharing plan. The earlier one begins saving for retirement the better, but even owners late to the game may benefit from a qualified plan. Generally, full-time employees need to participate, but the benefits to owners who are older may often outweigh the costs of covering everyone.
If closer to retirement, an age-weighted defined benefit pension plan (DB), perhaps in conjunction with a defined contribution plan (DC) may be worth considering. A DB plan may be designed to target a percentage of pre-retirement income for retirement income. The less time one has until retirement, the more must be contributed — and deducted — to meet the benefit goal. Owners can make up for lost time, but it is best if the plan is established at least five years before retirement.
A DC plan targets a rate of contribution instead of a benefit. Since payout is whatever the account has grown to over time, many years of contributions and earnings are key to a large retirement benefit.
These are a few strategies a family business can consider, which can better position an owner for retirement. Mercer can help you evaluate those strategies and assist in implementation of these and a variety of other appropriate benefit plans.
This article was written by Lynne Stebbins, JD, CLU, ChFC, AEP, principal & senior legal consultant for Mercer H&B Executive Benefits. Lynne.Stebbins@mercer.com. Marsh and Mercer are affiliated companies owned by Marsh & McLennan Companies, Inc. Grand Rapids office location 125 Ottawa NW, Suite 400. 616.233.4240. Mercer H&B Executive Benefits, a service of Mercer Health & Benefits Administration LLC. In CA, d/b/a Mercer Health & Benefits Insurance Services LLC | CA Ins. Lic. #0G39709 | AR Ins. Lic. #303439