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

 

I. CREATING AND RETAINING VALUE

The single biggest problem for most company owners is their inability to extract and retain money distributed from their company. In the good times, they often take out significant bonuses and dividend distributions, but when the economy tightens they usually have to put it back in out of necessity. It is a known fact that nearly 80% of the net worth of most business owners is locked up in their business. So even though the company continues to increase in value (by increasing the retained earnings of the company), the net result is the reduced personal liquidity.

I call this lack of liquidity – margin. Lack of margin is not a good situation because there is no margin for error. If and when the economy tightens or if interest rates rise before the liquidity is restored, what happens? Where do you go for money? The loss of margin means that despite success, owners often live on the edge of economic disaster and ruin. We must remember there really is a difference between profit and financial independence.

What are some ways to resolve this problem? Besides cash distributions that are invested in an investment portfolio, there are two commonly used strategies for increasing wealth: 1) a well funded retirement plan and 2) a split-funded investment grade life insurance program. Both are tax efficient and provide a systematic way to transfer wealth from the company to the owner’s pocket. In looking back at several severe business cycles, the primary asset to sustain value throughout the convulsions is not bonds, not large cap value stocks, not commodities or real estate – but cash values in life insurance and annuities.

This is not meant to be a sales pitch, but rather a fact. While insurance companies in the past have failed, not one policyholder has lost money.

Let’s look at these two remarkable plans.

Corporate Retirement Plans

A well funded, tax deductible retirement plan is called a qualified plan. (It is called qualified because it meets the rules set out under the Internal Revenue Code.) The most common qualified plans are profit sharing plans and 401(k) plans. Contributions are tax deductible going in and the benefits are taxable coming out. The Department of Labor regulates these plans and the IRS determines if they receive tax benefits. Both regulatory bodies place requirements on the legal way to operate the plan.

In a profit sharing plan the first rule is qualification. All eligible employees must be included in the plan to be qualified. If the company is going to fund the program, then all employees have to be funded equally. But equally does not always mean a pro-rata contribution based on salary for each employee. Equal can mean the contribution is adjusted for social security benefits, age and compensation levels based on job titles. The common term for this assessment is cross testing and these rules allow the plan actuary to reallocate a significant portion of the contribution to the highly compensated executives. I have seen plans where 85% of the total contribution goes to the top executive(s) – i.e. the owner – and still meet the qualification rules.

In addition to these rules, all funds have to be protected in a trust and the trustee (generally you) has fiduciary liability if the plan is not run properly. The funds have to be properly allocated as to risk and the employees need to have some communication on the quality and performance of the investments. If the fiduciary does not act properly, they have personal liability. This is why more and more plans are hiring Registered Investment Advisors to help protect against this liability.

There are basically two types of qualified retirement plans – defined benefit (DB) plans and defined contribution (DC) plans.

Defined Benefit Plans

A DB plan specifies the benefit to be funded. Once this benefit is defined, an actuary then calculates how much it will cost each year to fund the benefit. The funding is based on a targeted amount at retirement. The funding can change based on the investment performance. So it is possible the plan could cost a lot less if the investment performance is higher than was originally estimated. But it can also cost a lot more if investment performance is less than originally projected. This cost is determined year to year.

Benefits are usually based on age and salary. So if there are a lot of younger participants, it might be very possible a defined benefit plan for the entire company could be implemented for a very reasonable cost with the top paid, older executives getting the highest share of the contribution.

Defined Contribution Plans

A DC plan takes a percentage of company profits and allocates it among the participating employees. The cost is defined by formula and cannot be arbitrarily increased. The contribution will grow over time but the benefit will fluctuate because of investment returns. Here is where we can use the rules to help shift costs. By cross testing (described earlier), much of the contribution can be allocated to the highly compensated, if this is advantageous and what you want to accomplish.

Another way to increase the benefits to the highly compensated is to use a safe harbor(SH) contribution. This means your plan is guaranteed to remain qualified while in operation, if you follow the SH rules. Doing this eliminates all of the discrimination tests the IRS uses to determine if the plan is discriminatory year to year. Here is why SH is so valuable.

Essentially, the government says the Highly Compensated Employees (HCEs) cannot benefit disproportionately in a retirement plan. A test determines if the non-HCEs (all the rank and file) are receiving less than 2% in contributions compared to the HCEs. All eligible participants count whether they contribute or not. So if the non-HCEs average 4% of compensation, the HCEs can only put in 6% of compensation. If they put in more, the plan could lose its qualification. The bad thing about this calculation is that ALL employees who are over age 21, work full time and have been with the company longer than 1 year are eligible. And they count in the calculation of total employees whether they contribute or not.

The safe harbor match eliminates this problem. A safe harbor match allows the employer to match the first 3%, dollar for dollar. The next 2% is matched at 50% per dollar. This totals 4% of compensation if the employee contributes 5%. By doing this, the HCE can contribute any amount they want up to the annual IRS limits.

There is another approach called the “safe harbor profit sharing contribution” which also eliminates all testing. This option requires the company to contribute 3% of everyone’s pay who is eligible. Usually this approach is more expensive than the match because the company must contribute to all eligible employees. But it accomplishes the same objective; it allows the company to pass the IRS qualification tests and allows the owner to put away a significant contribution for himself.

Both the SH profit sharing contribution and the SH match MUST vest 100% from day one. But it is rare to find employees who will leave just because they are vested in the plan. They still have to pay the penalty tax and the income tax to withdraw the money. But of course, it could happen. The cost of the SH match is limited only to those who participate. But because it eliminates the HCE test, the top executives can put away as much as they want up to 15% of compensation – the maximum. However, by combining the profit sharing and the 401k, these plan designs can allow the owner to contribute up to $50,000 annually if they are over 50 ($45,000 if they are not) and earn more than $100,000.

How Do You Justify Funding Costly Benefits For The Rank And File Employees?

Let’s assume you give cost of living raises to the employees frequently. Those would be typically 3-4% of payroll. A raise would be taxable and subject to payroll taxes. So it is possible a 4% cost of living raise would only put 60% in their pocket with 40% going to income and payroll taxes. Maybe less. But if it goes into the qualified plan, 100% is invested for the benefit of employees. That 40% savings will be leveraged for the benefit of someone – either the corporation (in tax deductions) or the employees through increased contributions. The net result is this: the top executives would receive approximately the after-tax cost of the plan, which is the real cost of the plan. This makes the plan very efficient because the government paid for the rank and file employees. The after-tax cost funded the top executives and the owner’s benefit.

Capital Split Dollar – Split Funded Life Insurance

As discussed, the qualified plan must include all employees. What if you want to do something just for yourself or for your key employees? Another tax efficient benefit is what is often called the split funded life insurance plan. This plan is discriminatory and allows the corporation to offer a significant benefit just to the HCEs. There are two ways to do it. One is with after-tax company contributions. The other is to use leverage. The corporation could borrow the contributions and deduct the interest. This is a way to provide the benefit and not have any company capital in the plan. Proper design makes the ultimate benefit exactly the same, but the cost savings due to the tax deduction significantly reduces the company’s cost if it can qualify.

Split funded (sometimes referred to as split dollar) life insurance programs were a very popular benefit for decades, dating back to 1955. The corporation would loan the premium on an insurance policy to the employee and the owner of the policy would have the benefit of all the cash value net of the loan. Over many years, this could amount to a significant amount of cash value which would then provide tax free distributions through policy loans during retirement.

The IRS finally decided to close this “loophole” in 1998. In 2003, they came out with new regulations that significantly changed in the economics of the plan. Fortunately, this opened up the leverage opportunity. With leverage, instead of the company putting their capital into the plan, it could borrow the premium in a lump sum and deposit it over the first three years. This would supercharge the accumulation in the plan. Even though it is a loan to the corporation, there is no impact on the company financial statement. The company can deduct the interest on the loan and the owner of the policy still receives the net growth tax free so long as the policy does not lapse. The internal rate of return (IRR) of the leveraged plan can be in excess of 12% in most cases. It can be over 20% depending on how the costs are paid.

Other Benefits

There have been many other programs designed for business owners but the IRS has made changes to minimize or eliminate their effectiveness. Programs like Retired Lives Reserves, Welfare Benefit plans, 412i pension plans, and Section 79 plans were all opportunities in the tax code to provide deferred compensation benefits for the highly compensated. Some of these are still viable and can be utilized. But you need to be careful when a promoter comes to you with a “good idea.” Many of these good ideas have no real economic substance and could be a tax trap, waiting for the unwary. So be sure to get good counsel and look for an opinion letter from a reputable law firm that is covered under Circular 230.

The Three Most Basic Problems Every Owner Faces

Before we look at the other two questions, let’s look at the three basic problems common to every business owner. If the owner cares for their employees, these problems need a viable solution. Good stewardship demands the business owners create a contingency plan in the event of his 1) death, 2) disability or 3) changes in the ownership structure of the company. It takes time and thought to put a satisfactory plan together. But without this planning, everything you worked for could fall apart when you are not there to manage the outcome.

1) Disability – Ask yourself this question. Can you afford to take a 6 month vacation and never call the company to see how things are going? If we are honest, most of us would say “no way.” Yet that is exactly what could happen if the heart attack comes up short.

No one ever thinks this will happen to them. But it does happen. And when it does, it means there is no one to run the company. Worse, since 90% of all business owners are dependent upon their company for their income, it means a wounded company has to use its cash flow to fund the owner’s income while trying to remain economically viable. This is hard to do.

Fortunately, there are quality, tax deductible disability programs available either on a group basis or an individual basis to help fund any income shortfalls. In addition, there are business expense policies to reimburse expenditures used to pay overhead during disability. Most disabilities last less than 30 days. But the ones that go longer can last 6 months or longer.

2) Death – If you became part of the grill on a Mack Truck going home tonight, havoc would likely reign in your world. Everything would stop and all options would suddenly be on the table; options you may have rejected while you had the choice. Heirs often just shut down the business. Your spouse may have to sell your house. What would happen to the kid’s college education? How would your family pay for food? It can get down to the basics real fast. And to the extent you have provided some margin, how long will that margin last? Many families suffer tremendous economic loss, in addition to the emotional loss, when the money machine stops producing money.

Most families have less than 6 month’s income in cash or cash equivalents. National statistics show the average household has less than $50,000 of life insurance. The reason? Cost. Yet, a $1,000,000 term policy often costs less than $500 a year. Is this a false economy? Again, it always comes down to trade offs. The motorcycle, boat, Jet Ski, or family ski trip often competes with providing financial stability in case the unimaginable happens. And in the final analysis, I have never seen anyone who has provided adequately for their family actually have to give up any recreational opportunities. It is only the fear of it that prevents people from taking action.

3) Business Continuity – As a business owner, this is where the rubber hits the road. What happens to your business if you don’t make it into work tomorrow? This almost happened to me. I was driving a car on the desert between Barstow and Sedona, Arizona. It flipped at 75mph and landed smack dab on the roof. The car was absolutely demolished. But I walked away with no injuries. It could have been a whole lot different. If I had perished, who would fund payroll? What do you tell your vendors? The customers? Who runs the business? Who makes the rain? The point is, when you stop, will everything else stop?

Contingency Planning

A contingency plan is important. A business that is dependent upon the efforts of the business owner to survive is particularly vulnerable. So having a continuity plan in place, a contingency plan for shutting down the business, shoring it up, continuing to have it run is important. Who will call the shots? Who will make sure there is money to pay the bills? How does the ownership transfer if that is necessary? Any business owner who cares about his company and his employees would want to take time to think about these issues. Have you?

Many business owners have a buy-sell agreement especially if they have a partner. But a buy-sell agreement funded with life insurance doesn’t do the whole job. It is certainly a good first step. But it does not address the bigger issues such as, can the company remain a going concern? Who will be the boss? Will the employees stay? Will the customers go? So building an organizational chart that is not dependent upon you is a good first step. There are a lot of professional consultants who can help you think through these issues.

If you do have a partner, then you absolutely need to have a written buy-sell agreement. Here are five important issues that every buy-sell needs to address.

  1. What happens in the event of death?
  2. What happens in the event of disability? What is the definition of disability?
  3. What happens in the event one of the partners goes bankrupt?
  4. What happens if one of the partners gets a divorce?
  5. What happens if one of the partners wants to retire or sell?

I have seen a lot of buy-sell agreements through the years. Most would get less than a C grade. I saw one just recently where the agreement gave either partner the ability to sell their interest. But the agreement was written so the partner who wanted to buy the other’s interest, was forced to sell at the same price, first. It was what might be considered a poison pill. So unless you wanted out, you were frozen and there was not a way to extricate yourself from a relationship that wasn’t working.

In another instance, a widow was stuck with her husband’s partner. He was a cantankerous, older gentleman who couldn’t understand why the business was not doing as well now that the boss was dead. The widow had untold grief and stress trying to resolve issues that could have been resolved with some planning.

It is so important to make sure your agreement is written by a qualified attorney who knows the issues and the solutions, and can guide you through the thought process to avoid obvious errors.

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