Retirement Planning

Looking ahead to the day when you can stop working and retire may be a pleasurable notion, and something to keep you going when you're working round the clock, dealing with business crises, and worrying about how you'll meet the next payroll. Many business owners expect that the sale of their business will provide them with the funds to have a financially secure retirement. Unfortunately, this doesn't always happen, especially if they sell during an economic downturn or their industry falls out of favor.

The best way to make sure you have the money to provide you with a comfortable retirement is to optimize your retirement savings. Chapter 16 discusses your retirement plan options, the rules for making annual contributions, and annual reporting requirements. Now let's focus on ways to optimize the returns from your retirement plans.

Exit Strategies

There may be a variety of reasons why you leave your company. They include retirement, disability, being a serial entrepreneur (selling this company to start another one), or death. Whatever the reason, there are several exit strategies.

Before you make any plans, it is a good idea to determine what the business is worth now (the value may change in the future, but plans can be adapted to accommodate valuation shifts). This is done by obtaining a business appraisal. There are various formulas used to determine the value of a business:

• Asset and earnings valuations (factoring in intangibles such as goodwill)

• Asset-based formulas (based on book value or liquidation value)

• Comparable sales of similar businesses

• Earnings (revenue) formulas (multiples of revenue or capitalization of earnings)

Resources to help you find a qualified appraiser (someone with the requisite professional experience who meets certain standards) include the following:

• American Business Appraisers (www.businessval.com/)

• American Institute of CPAs—Accreditation in Business Valuation (http:// apps.aicpa.org/credentialsrefweb/ABVCredentialSearchPage.aspx)

• American Society of Appraisers (www.appraisers.org/BVhome.aspx)

• Institute of Business Appraisers (www.go-iba.org)

You can use free online tools to learn the approximate valuation of your business. These tools are no substitute for an actual valuation by a qualified appraiser. Free tools are available from:

1. BizEquity (www.bizequity.com)
2. BizEx www.bizex.net/business-valuation-tool)
3. Free Valuations Online (http://freevaluationsonline.com/)

Financing Options to Fund Buyouts

Buying out the interest of a departing owner can be paid for in a variety of ways. Most common are:

• Company buyouts. The interest of the departing owner is acquired by the business, leaving the remaining owners with greater ownership interests. The company may set aside money for this purpose (e.g., a corporation may use retained earnings to buy out a retiring owner). Alternatively, the company may pay for the departing owner's interest through profits over time. If the company buying the interest of a departing owner is incorporated, this is referred to as a stock redemption.

• Life insurance. Usually, insurance is used to buy out a deceased owner's interest. However, insurance can also be used to pay for a retiring owner. Work with a knowledgeable insurance agent to structure insurance financing for a buyout.

• Installment sales. A departing owner may sell an interest under an installment payment agreement.

• ESOP. An employee stock ownership plan (ESOP) can be used for a corporation (C or S) as a way to buy out the shares of a departing owner. ESOPs are explained in Chapter 16.

In the past, private annuities were often used in family situations to transfer ownership to the younger generation at favorable transfer tax costs. However, changes in the tax treatment of private annuities mean this method is no longer used.

Consulting Agreements

If you retire but want to continue your association with the company, negotiate a consulting agreement. Being a consultant means you are a self-employed individual who is paid a fixed amount for consulting services over a set period (typically 2 to 5 years following a buyout).

From the company's perspective, consulting fees it pays to you are fully tax deductible. There are no payroll taxes with respect to consulting fees.

Estate Taxes

If your net worth (the value of your personal assets, including your business interests) are more than the federal estate tax exemption amount ($5.45 million in 2016), then succession planning must include estate tax concerns. Your state may have a death tax imposed on estates valued at less than the federal exemption amount (e.g., $675,000 in New Jersey, $1 million in Massachusetts, $2 million in Maryland and the District of Columbia, in 2016), making tax planning important even for more modest estates. If you fail to address estate taxes, your family may be forced to sell your business (or your ownership interest) at a fire sale price in order to raise the cash needed to pay the estate tax bill.

Estate Planning Concerns

When you die, if you have not made any special plans, your business interest passes to your heirs according to the terms of your will or state law governing intestacy when there is no will. However, you are free to make whatever plans you want when it comes to your business interest.

Factors in estate planning decisions. Is there a relative (e.g., spouse or child) who already works in the business and is your natural successor to run the business when you die? Or does your family want nothing to do with your business after your death? Do co-owners prefer to take over your ownership interest? Answering these questions can help direct you toward the best way to decide now what will happen to your interest when you die.

Buy-sell agreements. These are contracts among co-owners of a business to fix the actions that will be taken when one owner dies. There are 2 basic types of buy-sell agreements:

1. Redemption-type agreements (also called the entity plan). Here the business buys back the deceased owner's interest, leaving the remaining owner or owners with greater interests. For example, say there are 2 co-owners who each own half of a limited liability company. When one owner dies, assets of the company are used to buy back the deceased owner's interest, leaving the remaining owner with 100% control. If the business is incorporated, the buy-back is done through a redemption of the deceased owner's stock.

2. Cross-purchase agreements. Here each remaining owner buys out the deceased owner's interest. Say there are 3 equal co-owners in a corporation. When one owner dies, the remaining 2 buy half of the deceased owner's stock, leaving each remaining owner with a 50% ownership interest.

There are also hybrid agreements that use elements of each type of basic agreement to accomplish their goals.

From a tax perspective, as long as the buy-back is fixed and there is a mechanism for setting the buyout price, the IRS usually will respect the agreement. This means that the price paid under the agreement can be used to set the value of the ownership interest for estate tax purposes.

Funding buy-sell agreements. In most cases, life insurance is used to pay for the buyout at death. If the corporation receives the life insurance, use care to avoid unwarranted income tax effects. If a C corporation is involved, the alternative minimum tax (AMT) may be imposed, depending on the corporation's pretax profits and preference items for income tax purposes.

From your perspective, consulting fees are earned income for purposes of the 0.9% additional Medicare tax. You may want to set the consulting fees below your threshold amount ($200,000 if single; $250,000 if married filing jointly; $125,000 if married filing separately), factoring in any other earned income you may receive.

Special estate tax rules. If a business owner's estate is sizable, meaning more than the applicable estate tax exemption amount ($5.45 million in 2016), there may be federal estate tax as well as state death taxes. These taxes typically must be paid within 9 months after the date of death. However, estates of business owners enjoy certain special tax breaks:

• Special valuation for closely held business real property. Instead of valuing the realty at its highest and best use, it can be valued according to its actual use. This can considerably reduce the value of the property included in the owner's estate.

• Tax deferral. If the decedent's interest in a closely held business exceeds 35% of the adjusted gross estate, the estate can elect to defer the payment of estate taxes. Deferral means that only interest is due during the first 4 years; taxes plus interest are then paid over the following 10 years (for a total deferral period of 14 years). A 2% interest rate applies to the tax attributable to the first $1.48 million of the taxable estate for owners dying in 2016 (this dollar amount may be adjusted in the future).

• Stock redemption to pay estate tax. If the closely held business interest exceeds 35% of the gross estate (minus certain deductions) and the business interests remain with the family, then the estate can elect to have the stock redeemed in order to pay estate taxes. This can be done without incurring income tax liability on a partial redemption of the stock.