The Importance of Converting Equity to Capital

Guy Baker By
Guy Baker

MBA, MSFS

 

  1. Introduction
  2. The Beginning
  3. Why have a business entity
  4. To Pass Through or not
  5. Closed Entities and Pass through entities
  6. The benefits of owning a closed entity
  7. The Three Circles of Wealth – The Common Denominator
  8. The Three Big Questions
  9. I. Creating and Retaining Value
  10. II. Keeping Superkeepers
  11. III. Exit Strategies
  12. Additional strategies to build and retain wealth
  13. Conclusion

 

Additional Strategies To Build And Retain Wealth

Making this decision, I have found, is the hardest thing for any business owner to do – diversify risk and cash flow. They are always fighting the cash flow boogie man. They often get too conservative and are reticent to make any long-term commitments to a wealth accumulation plan for fear they will need the money if the business cycle turns. And unfortunately, this has happened. But when was the last time the company’s success depended upon your outside capital? But more important unless it is down to survival, your money should be the last source of capital, not the first. Unfortunately though, it is often the first source.

Whatever your situation, here are some exciting ideas you need to consider while time is on your side. Now, don’t misunderstand me, you don’t need to do all of them. Actually, you don’t need to do any of them. But the purpose of this booklet is to introduce you to some of the strategies we are seeing business owners use to diversify their risk and build capital for their low stress years.

Captives – Many companies have risks that are uninsurable. If the uninsured event occurs, it could destroy the company. These risks are unique to each company. Congress authorized the formation of small captive insurance companies to help fund these risks. There are some very specific rules, but the rules allow each corporation to make deposits into a tax exempt entity for this expressed purpose.

You own this tax exempt entity – called a captive company. All the money accumulated in the company is invested and reserved in case of a claim. But if the claim never materializes, the assets remain in the captive and increase in value, as the captive grows. Since the premiums are tax deductible, a captive can be a significant long-term wealth accumulation tool for shareholders.

There are limitations and rules that have to be followed. There are also administration costs and reinsurance costs annually. But the set up cost is about 5% compared to a tax cost of 40% on the premium. When the company is liquidated, the retained earnings are taxed as capital gains. This would seem to offer a significant cost benefit ratio.

LTCI – Extended health care costs are a growing concern. Long term care insurance is becoming more important as a benefit. The statistics now show 1 in 2 people who reach age 70 are likely to need some type of special care before they die. How to best provide for this health care service is a nagging question. Most wealthy families would prefer to stay in their home rather than go to a senior housing facility. Medicare and Medicare supplements do not currently cover daily home care. What is the best way to finance these health care costs?

Based on our experience, the best way to cover costs that can last 2.5 years on average is to purchase long term care insurance. These plans pay a monthly benefit which can be used to pay for any type of services at home or in a care facility. The benefit payments are income tax free and the premiums are tax deductible if paid by the corporation. You can also pick and choose who you want to cover. So this can be a highly compensated executive only benefit.

Long term care insurance is a very important benefit for most families. It protects the family’s wealth from liquidation and guarantees the family income is not going to be dissipated for health care to the detriment of the non-infirmed spouse. We have even seen the super wealthy purchase this coverage as a hedge against market turmoil.

419e – You have probably heard some of the negative publicity associated with welfare benefit plans. Many of these plans deserve the bad press. But there are still some plans that meet the spirit of the law and conform to the IRS guidelines. What makes a 419e so attractive? The strategy is a lot like the captive. You accumulate money in a trust for the purpose of funding health benefits. It can be used to buy life insurance, to pay co-pays and deductibles. It can also pay premiums on long term care and medical care supplements.

The plan utilizes the same rules as qualified retirement plans. All full time employees must participate in the plan for it to qualify for the tax deduction. But there are certain eligibility rules that allow latitude in the cost and structure of the plan. This can be a meaningful benefit for the owners of the company who often outlast most of their employees.

Defined Benefit plans – The IRS announced in 2005 they were going to scrutinize all 412i defined benefit plans. Why? Previous plans were deemed to be too aggressive and abusive in operation. What is a defined benefit plan? You can refer to the previous discussion. But to summarize, it is a plan that defines a benefit and then funds for that benefit using age and compensation variables. The funding is actuarially calculated based on certain interest assumptions and is adjusted annually based on actual performance. The lower the interest assumption is the higher the cost of funding the benefit.

Even though the benefits were reduced by the IRS audits, 412e(3) plans still provide substantial benefits and are worth analyzing as a way to build retirement wealth for business owners.

401(k)s – For a long time, 401(k) plans were not useful to the highly compensated or the owners of the companies. But Congress has remedied that problem by putting in guidelines for minimum contributions to the non highly compensated. So for employers who are willing to meet those guidelines, not only can the highly compensated executives contribute a lot of money, the plan can be designed to avoid expensive testing.

It is possible, with a well constructed plan for the owner to put away as much as $50,000 a year under current limits. However, it is important to note qualified plan assets become tax inefficient if you have a large net worth. These accounts are subject to both income and estate taxes, making the total tax in excess of 75% in most cases. The same is true for money accumulated in a defined benefit plan. So unless you are planning on taking significant distributions during your lifetime, these plans may be undesirable. Again, a wealth advisor can help you determine the benefits for your specific situation.

Capital Split Dollar – An alternative to selling stock or putting in a qualified plan for your superkeepers is to implement a Capital Split Dollar benefit plan. This strategy calls for the company to lend significant premiums to the executives for a period of 10-15 years. The money is invested in a capital rich insurance policy designed for maximum accumulation. The cash account grows tax free until the executive is ready to borrow from the account during retirement. If the corporation borrows the capital for the plan, the interest on the loan is deductible, making Capital Split Dollar the only leveraged program with tax deductible interest.

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