Despite their reputation, traditional defined benefit (pension) plans can be a valuable tool for small business succession planning. Defined benefit pension plans are often associated with unions and financial mismanagement resulting in severe underfunding and government bailouts. They are often viewed by many within the retirement plan industry itself as a relic. However, the annual contributions that may be made to a defined benefit plan often dwarf annual contributions that may be made to a 401(k) plan. For this reason, small business owners who are nearing retirement age often find defined benefit plans an attractive means of saving a large amount for retirement over a five- to ten-year period. And under the right circumstances, a defined benefit plan may help finance the sale of a small business to a younger generation.
Contribution and Deduction Limits Impact Small Business Owners’ Retirement Savings
Annual contributions allowed on behalf of a single participant in a 401(k) plan are limited. For 2022, the maximum combined employer and employee contributions are $61,000 per participant (employees age 50 or older may make an additional $6,500 in catch-up elective deferrals). Over the life of their business, small business owners often reinvest heavily in their business at the expense of saving for retirement. As a result, a 401(k) plan by itself may not be sufficient for a small business owner to save for retirement over a reduced number of years.
In a defined benefit plan, however, an actuary determines the minimum required and maximum permitted annual employer contributions. The contribution range depends generally on the participants’ ages, compensation history, and benefits accrued and also on the value of assets already held for investment by the plan’s trust. Annual contributions to a defined benefit plan due to an older, highly paid participant (i.e., a business owner) can be $300,000 or more. Note that a defined benefit plan can be designed to permit lump sum payouts (instead of the typical monthly or annual benefits paid until death). Under current Internal Revenue Service limits, the optimal defined benefit plan participant is eligible for a defined benefit plan lump sum payout exceeding $3 million, and the lump sum may generally be rolled over to an individual retirement account (IRA) or another tax-qualified retirement plan where it continues to earn tax-deferred investment returns.
Using a Defined Benefit Plan for Business Succession Planning
A defined benefit plan may fit into the sale of a business because it reduces the buyer’s cost to buy the business while providing tax-deferred compensation to the seller. For example, take a situation where a business owner wants to sell the stock in her corporation to a younger key employee (or group of younger key employees). As is typical with such a sale, the business owner will remain an employee for a few years following the transaction to ensure a successful transition. In anticipation of the sale, the seller sets up a defined benefit plan and begins accruing benefits under the plan a few years before the transaction while keeping funding to a minimum. At the point of sale, the stock sale price is reduced by the amount of the contributions needed to fund the former owner’s pension benefit. During the period following the transaction (while the former owner is still employed), the corporation makes contributions to the defined benefit plan to fund the former owner’s accrued benefit. In effect, this enables the buyer to fund part of the stock sale with tax-deductible pension plan contributions and provides the seller with an income-tax-deferred benefit. As an added bonus, the defined benefit plan is designed to permit lump sum payments. At retirement, the seller receives a lump sum distribution that is rolled over to a traditional IRA (an event that does not trigger income tax) where it continues to earn tax-deferred investment returns for years or even decades following the sale of the business.
It should be noted that there is a trade-off here. The proceeds from the sale of the business are normally subject to capital gains taxes, but distributions from a tax-qualified retirement plan or an IRA are generally subject to income taxation (and income is typically taxed at higher rates than capital gains). It is important that a business seller consult with a CPA (a certified public accountant) or trusted financial advisor to determine whether use of a defined benefit plan is likely to result in a better outcome for the seller.
This article summarizes aspects of the law and does not constitute legal advice. For legal advice for your situation, you should contact the author of this article.