Small-business owners commonly are stereotyped as plowing all of their revenue back into their businesses. This leaves them dependent on a large liquidation event for their retirement. Typically, this involves a sale of the business.
However, a sale can be very problematic. Many business owners have never developed the infrastructure necessary to make taking over the business attractive to a third-party buyer. In other cases, the revenue of the business may simply be too dependent upon the skills and relationships of the business owner for there to be anything of real value that can be sold. If there is a second generation available to take over the business, then converting ownership into liquidity is even more problematic.
The solution to these problems in some cases may be a qualified retirement plan. Many small-business owners do not have any retirement plan, or they only provide minimal retirement benefits primarily for their employees, without any regard to their own retirement. In part, this results from the owner’s preference toward reinvesting in the business. However, few business owners are aware there are qualified retirement plan alternatives that can provide a hedge for retirement if their big liquidity event never materializes.
The kinds of businesses for which this approach may be suitable are endless. Imagine a successful home health care company largely dependent on referrals from physicians with whom the owner has developed personal relationships. How about an individual whose manufacturing business is dependent upon his skills and experience? The business may be very lucrative, but it lacks the manufacturing and financial infrastructure to be successful without the owner’s involvement in nearly every facet of the business. Although successful, the business may not be attractive to larger companies because the products and services are not so unique that they cannot be obtained elsewhere in the marketplace without the headache of buying and figuring out how to run the owner’s operation.
If the objective is to create an arrangement where the business owner can put away a lot more money for retirement than the average 401(k) plan, then one possible solution involves cross-testing. All qualified retirement plans place limits on the amount of compensation upon which benefits can be based, and on the benefits that can be provided to the highly compensated employees as compared to the non-highly compensated employees. Basically, these are the nondiscrimination requirements. In 401(k) and similar “defined contribution” plans, it is the contributions that are generally tested for discrimination. Cross-testing is simply an innovative approach to converting the contributions to benefits and then testing the benefits for nondiscrimination. This innovation can greatly enhance the benefits available to the business owner. The benefits can be further enhanced by adding a second plan, such as a cash balance pension plan.
A cash balance pension plan is a type of pension plan, except that instead of providing a benefit based on a formula using compensation and service, the benefit formula is based on a hypothetical account balance consisting of two parts:
1. Pay credits (a percentage of compensation), and
2. Interest credits (e.g., a fixed rate up to 6 percent).
Both employers and employees tend to like cash balance pension plans because of this easy-to-understand benefit formula.
The employer’s deduction in the case of a cross-tested 401(k) or other defined contribution plan is 25 percent of payroll. In the case of the cash balance pension plan, the employer may deduct whatever amount is required to fund the employees’ benefit. For 2017, the maximum “annual addition” under a defined contribution plan is the lesser of 100 percent of compensation or $54,000. The maximum annual benefit under a defined benefit pension plan is $215,000. The maximum compensation for an individual that can be taken into account under a qualified plan is $270,000 in 2017.
While most small businesses these days provide at least a basic retirement plan for their employees, a carefully thought out retirement plan or combination of retirement plans can serve as part of the business owner’s succession plan. By accumulating some funds inside a retirement plan, instead of exclusively inside the company, a business owner can help alleviate the problem of relying upon a buyer for the business to fund the owner’s retirement.