Learn how a cash balance buy-out can help you negotiate the sale of your construction company.
Today, many businesses-including construction companies -are experiencing a sobering problem: what to do when it comes to owners who want to sell their share in the business to younger members of the company. It can be difficult enough to negotiate a sale of an owner's interest, and finding a way to pay for it is an even greater challenge.
A unique retirement plan variation can grease the skids of an exit strategy and leave all parties in a win-win situation. This would involve the creative use of a special retirement hybrid known as a cash-balance plan. In the context of a partnership buy-out, a cash balance plan can be incorporated as an overlay to an existing 401(k) plan and create the opportunity for massive retirement plan contributions for older people in their 60s. By massive, I mean something in the neighborhood of $150,000 per year for many business owners approaching retirement.
The typical dilemma for younger owners of a business such as a construction company stems from their need to come up with after-tax dollars to buy out an owner who is retiring. This means that a payment of $500,000 will cost $1,000,000 in pre-tax dollars. The dollars are then taxed at capital gains rates to the departing partner who probably has a cost basis of zero if he or she is an original founder of the business. Therefore, the entire amount of the sale proceeds will be taxed at capital gains rates. In simple terms, more than half of all the money required at the start of the transaction will be paid in taxes by a combination of the buyer and seller.
The beauty of incorporating a cash-balance plan into the mix is that the contributions are a tax-deductible expense for the company and its remaining younger business owners. For the seller, the deposits are tax-free- or at least tax-deferred- until the retiring seller begins spending the money years later in retirement. Moreover, the money in the plan can be invested and compounding on a tax-deferred basis over the years.
How Does It Work?
In an actual example of a small construction company with an owner and a handful of employees, we start by calculating a yearly "service credit" for each year the firm's owner has worked. In an actual recent case, this turned out to be $25,000 a year for the 25 years this professional had been self-employed- a total of $600,000 becomes the "opening balance." "Opening balance" is the amount of money he should have had by now if he had started saving years ago. Since he wants to retire in five years, we extend the $25,000 annual service credit out for that length of time compounded at 6 percent per year. The $600,000 opening balance is also compounded out for five more years at 6 percent. The total of the two numbers is just less than $1,000,000.
Now, we work backward to determine how much money has to be contributed over the next five years to accumulate the $1,000,000 lump sum funding level we have just calculated. An annual tax-deductible contribution of $175,000 earning 6 percent for the next five years will do the trick. Fortunately, with the business in its prime of life, this owner could afford to make those tax-deductible contributions.
Meanwhile, what about other employees in this small business? Typical turnover at small construction companies generally means that not many people have worked long enough to have accumulated much in the way of an "opening balance." This reduces the lump sum to be funded for them. Also, their younger ages as a group allow us to use a much lower service credit. The service credit for this business owner is 12.5 percent of current salary. The other employees have a 2 percent of current salary service credit, because hypothetically, they have the advantage of about 30 years until retirement. This means that the business owner will contribute about $15,000 for a handful of younger employees as a cost for the right to contribute $175,000 into his own account. A further advantage is that each employee has his or her own specific account. The employee can actually see his or her money as opposed to just a vague promise of an "accrued benefit" that may or may not be adequately funded.
The cash balance plan, in this small company environment, offers a tremendous advantage for older business owners. This example was extreme, to illustrate the point, but this vehicle can be incorporated as an overlay to existing 401(k) plans to "supercharge" the contribution levels and accomplish more for senior owner/employees who find themselves "behind the retirement eight-ball." Employers view their contributions for employees (required of only the lowest-paid half of the non-owner employees) as a good bargain. Many reason that they are just giving to their associates a portion of what they otherwise would have paid in taxes.
In the case where the tool is used to fund the business interest buyout of a senior partner, younger partners are treating the substantial retirement plan contribution as installment payments for his or her ownership interest.
People selling business interests later in life too often assume the value of their stock amounts to what they have calculated as that final nut to fund their retirement lifestyle. The sales price in their mind's eye has been "grossed up" to cover the estimated capital gains tax on the sales proceeds. The nicest people in the world can rationalize what is in their self-interest. Buyers, of course, care only about what the business can support financially. Emotional benchmarks mean little or nothing, and this disparity in priorities can bring negotiations to a standstill.
Judicious use of the cash balance plan-before it gets too late-begins the process one step at a time. Practiced over a number of years as part of the sales process, it relieves the pressure of having to come to terms with a single, final, large number.
Construction Business Owner, December 2010
