Using Retirement Plans for Succession Planning

The Role of Retirement Plans in Succession Planning

Retirement plans, commonly offered to employees as part of their compensation package, can also serve a dual purpose in succession planning. These plans allow businesses to set aside current earnings into retirement accounts, deferring taxes until distributions are made. By contributing to these plans, businesses can effectively transfer assets out of the company, reducing its overall value and making it more affordable for potential buyers.

For owner-employees, this strategy is particularly advantageous. The assets transferred into the retirement plan remain under the owner’s control, albeit in a different form. This can provide flexibility in managing the sale of the business, enabling the owner to sell at a reduced price while deferring taxation on the value set aside in the retirement plan.

Types of Retirement Plans and Their Strategic Use

1. Defined Benefit Plans: These plans promise a specific benefit amount upon future distribution and are typically more complex and costly to manage. However, for smaller middle-market companies, defined benefit plans can offer substantial value, particularly for older business owners. Contributions to these plans can exceed $200,000 per year for individuals over age 60, providing a significant means of reducing company value.
2. Defined Contribution Plans: These plans are easier to manage and less costly than defined benefit plans, as they promise a specific level of employer contribution rather than a fixed future benefit. Profit-sharing plans, a type of defined contribution plan, offer flexibility in employer contributions, which can be tied to company profits or other factors.
3. Nonqualified Retirement Plans: These plans do not meet the rigorous qualification requirements of other retirement plans, offering greater flexibility. They can be customized to suit the needs of key executives or owners, allowing for higher contributions and more tailored vesting schedules. However, they do not offer immediate tax deductions for the business, making them less favorable from a tax perspective.

Considerations for Implementing Retirement Plans

When considering the implementation of retirement plans as part of a succession strategy, it is essential to weigh the benefits of deferring taxes and reducing company value against the potential tax implications. While qualified plans offer immediate tax deductions, nonqualified plans can provide greater flexibility in terms of plan design and benefit allocation.

Business owners must also consider the long-term commitment required for these plans to be effective. Unlike Employee Stock Ownership Plans (ESOPs), which can be structured to purchase the business over time, retirement plans generally require a longer period to accumulate value and achieve the desired reduction in business value.

Conclusion

Retirement plans, when used strategically, can be a powerful tool in succession planning for closely held businesses. By reducing the company’s value through contributions to these plans, business owners can make their business more attractive to potential buyers, facilitating a smoother transition of ownership. However, the implementation of these plans requires careful consideration of the tax implications, plan design, and the long-term objectives of the business owner.