Inherent Tradeoffs-The Retirement Payoff
I’m still in shock! One of our young-20-something managers sat in on an initial meeting I had with a new client. Afterwards, she told a mid-20-something manager (who relayed the conversation to me) that she was impressed with how quickly I hit it off with this guy who was known to be a tough, 60-year-old codger. Now, get this. The explanation was that it must have been because of my gray hair! Whoa! Until yesterday, I was young. Now, I’m gray haired? Well, give me a break! Factually, I only have three gray hairs, although they seem to be becoming a more significant percentage of the total.
Anyway, as we careen wildly toward our golden years, it’s only natural to begin to think more and more about financial security for ourselves and our spouses. It can be tough when much of your net worth and your potential income stream depends upon the family business. The considerations and tradeoffs are mind boggling. They are why many aging business owners only “semi-retire.” They have to stick around to protect their retirement nest eggs.
Here are just some of the many dimensions to the retirement financial security issue. . .
Whose Priority is It?
Now that I’ve reached the gray-hair stage, I believe that the senior generation’s financial security is Job One for the company and your successors. Without that security, an owner is unlikely to turn over responsibility, ownership and control to the successors. Plus, if you spent your life and risked your fortune building a business, it seems only fair that you should enjoy at least some of the fruits of your labors.
The problem is that continuing the paycheck for a retired or semi-retired CEO can put a real strain on the business. Why? The company must pay two (or more) CEOs at one time, but probably isn’t getting double the benefit.
The need to build cash for estate taxes can stress the balance sheet even more. On top of that, the successors likely need additional business capital to fund their new strategies.
Here’s a hint. Financial security must be Job One not just for the company and successors, but also for the senior generation. Like the rest of the working world, a secure retirement requires starting early. Maybe the senior generation should start saving a bit before retirement so that it is not so dependent upon the business after retirement. Perhaps we shouldn’t burden the business with a huge, unfunded cost when it can least afford it.
Income Tax Considerations
There are an infinite number of ways that business owners and tax advisors have created to get cashflow out to semi-retired business owners. Consulting fees, deferred compensation, director’s fees, rabbi and secular trusts, off-the-books perks, plowing huge amounts of money into insurance policies that grow to fund the retirement benefit, renting property to the company, etc.
I saw one business pay rent to a semi-retired business owner for use of his prop plane. Ostensibly, he was the business’ good will ambassador, primarily wooing a prospective customer 25 miles away! According to the plane’s log, meetings occurred twice a month for several years, but the prospect never actually became a customer.
Suffice it to say that the IRS has an interest in this matter. Payments made to owners must be supportable based upon the value of the services received by the company. Stated more specifically, an owner’s overall compensation package must be reasonable for the services performed. If not, the company forfeits the deduction.
Think about this for a minute and you’ll see that the tax law actually encourages a little advance planning for retirement. Deferred compensation is the classic approach for retirement pay. The company simply agrees to pay the executive a percentage of his pre-retirement salary after retirement. If this agreement occurs on the day of retirement, the tax law considers it to be unreasonable because the company will pay many years of compensation for one last day’s worth of work. On the other hand, if the company and a 45-year-old employee reach the same agreement, the post-retirement pay is considered to be part of the package covering services from age 45 to retirement. That’s much more reasonable.
Once the retirement package is determined, the business can plan and budget for its retirement payment obligations. Perhaps you can put a little of your current compensation away for retirement, too. Talk with your tax advisor about the most efficient ways for both you and the business to do so.
Interaction with Estate Planning
You’d be surprised at the number of family business owners I meet who demand high retirement compensation with one breath, while fighting mightily to shift their estates to the kids in the next. Think about it. Does it really make sense to soak the business for retirement funds when your stock is worth umpteen gazillion dollars and someone will have to come up with the dough to pay the estate tax?
Logically, you should “spend” the value of your stock in your retirement years, so that there isn’t so much estate tax when you “check out.” The problem is that the grocery store won’t accept stock certificates. Is there some way to convert the stock to cash for retirement support?
Of course! You can sell all or part of your stock to your successors (or, with some tax caveats, to the company) in exchange for a note. The interest and principal payments provide cashflow for living needs. Compare that to holding your stock and taking retirement pay. In the latter scenario, the successors must buy the business twice - once through retirement pay and a second time in the form of estate taxes.
If you don’t want to give up control, you might be able to retain it through a recapitalization. Turn most of the company stock into nonvoting stock. You sell the nonvoting for retirement cashflow and retain the vote. Once again, your income and estate planning advisors can help you avoid tax traps and make this happen efficiently.
Whatever you do (or don’t do), keep in mind that the kids are watching. If you own the entire business, you can impose most any burden you chose. However, you will be setting a precedent that might be inappropriate for the next generation. “Mom got $250,000 a year for the rest of her life after she retired, so I should, too.” Perhaps so. But, I have seen next generation successors, each making wildly differing levels of contribution to the business’ success, and each expecting the same retirement pay as the founder received. I’ve also seen successors follow the parents’ lead of doing no planning.
This is not so much a function of what you can and cannot do as it is a function of doing what is right. We all get mad about the amount of money the government spends on welfare and social security for people who did not plan for their retirements. Hopefully, you won’t need to rely on the government to bail you out. But, perhaps you should try to plan your affairs so that you don’t have to rely too heavily on the company to support you either. In the long run, everyone will win. And, maybe you won’t have to get gray hair worrying about retirement financial security.