The equity out retirement planArticle added by Nicholas Paleveda MBA J.D. LL.M on May 3, 2012
Nick Paleveda MBA J.D. LL.M

Nicholas Paleveda MBA J.D. LL.M

Bellingham, WA

Joined: March 27, 2012

(continued)
One way to structure a small business owner's retirement is to have their company obtain a loan to fund their pension and profit sharing plans.

Tax arbitrage for a small business

A real problem for small business owners facing retirement is providing sufficient funds for their retirement. How do they get the equity out of their business on a tax efficient basis? One way to structure their retirement is to have their company obtain a loan to fund their pension and profit sharing plans.

The loan rates are generally in the 7 percent to 8 percent range. The income of the small business owner can place them in the 30 percent to 35 percent marginal tax rate. The small business owner, by borrowing funds for their corporation, can receive a tax benefit of 30 percent to 35 percent.

The interest rate on the funds may be 7 percent to 8 percent on the amount they borrow. The company then takes the taxes saved plus an additional loan to continue funding the plan. After a period of years, the loan amount can be reduced, and the amount in the plan becomes significant to help fund the retirement of the small business owner.

Equity out plan

A modern tax plan for a small company is to have the company borrow money to fund a pension plan and create an arbitrage on the difference between the tax rates of 35 percent and the borrowing rate of 7.25 percent. This form of tax arbitrage can work for small companies as well as large corporations. This plan also allows the purchase of the company at a later date by a junior shareholder.

Plan example:

1. Client age 60 applies for an equity out loan in the amount of $500,000.

2. Client contributes $250,000 to the pension plan for the company.

3. The company receives an income tax refund for $87,500 (35 percent bracket).

The client takes the tax savings/refund and places it into the plan the following year with additional borrowing. Over the next five years, the owner will build the pension to $760,777 (assume a 3 percent rate and the tax refunds are being reinvested into the plan) and can retire with an income of $4,614 a month or an annual income of $56,568 at age 65. The company will have a loan outstanding in the amount of $388,780, which will be assumed by the purchaser of the company.

Cost/benefits: year one

The loan year one: The loan is for $500,000. The company contributes $250,000 into the qualified plans. The interest rate is 7.25 percent, which totals $35,622.

The interest is deductible and the company receives a tax refund of $99,967 which is reinvested into the qualified plans.
Cost/benefits: five years

Loan cost: $162,638

Taxes saved: $ 299,126

Liability: loan outstanding $388,780

Asset: pension plan $760,777

Moving parts

There are several steps necessary to follow to create this result. There are also several moving parts. One part is the interest rate of the loan which can vary. Another is the marginal tax bracket of the company which can vary, and the other is the rate of return on the pension assets which can vary.

It is clear that if you can borrow funds at 7 percent and invest at 10 percent, you will be increase your asset base. If you borrow at 7 percent and invest at 3 percent, you will be decreasing your asset base.

What happens if you borrow at 7 percent, but receive a tax deduction and benefit of 35 percent? Once again, you will increase your asset base. This form of tax arbitrage is available for small companies as well as large corporations.

The Small Business Jobs Act of 2010

The Small Business Jobs Act of 2010 has allowed financing to take place for small business owners once again. Today, generally you can obtain a loan at 7.25 percent. The loan cannot be securitized by the pension plan since under federal law the plan is exempt from the claims of creditors.

The loan must be securitized by the assets of the company which in many cases is the cash flow of the corporation. The interest rate can vary based on the lender and the crediting rate of the company, however it is not unusual to receive a loan amount in the 7 percent to 8 percent range today.

The Pension Protection Act of 2006

The plan can be overfunded under PPA 2006. In this newly-minted tax act, Congress recognized that many pensions are underfunded, hence they have allowed pension plans to be overfunded up to 50 percent in excess of the target.

Under the Pension Protection Act of 2006, for taxable years beginning in 2006 and 2007, in the case of contributions to a single-employer defined benefit plan, the maximum deductible amount is not less than the excess (if any) of (1) 150 percent of the plan’s current liability, over (2) the value of plan assets.

For taxable years beginning after 2007, in the case of contributions to a single-employer defined benefit pension plan, the maximum deductible amount is equal to the greater of: (1) the excess (if any) of the sum of the plan’s funding target, the plan’s target normal cost, and a cushion amount for a plan year, over the value of plan assets (as determined under the minimum funding rules); and (2) the minimum required contribution for the plan year.

However, in the case of a plan that is not in at-risk status, the first amount above is not less than the excess (if any) of the sum of the plan’s funding target and target normal cost, determined as if the plan was in at-risk status, over the value of plan assets.
The cushion amount

The cushion amount for a plan year is the sum of (1) 50 percent of the plan’s funding target for the plan year; and (2) the amount by which the plan’s funding target would increase if determined by taking into account increases in participants’ compensation for future years or, if the plan does not base benefits attributable to past service on compensation, increases in benefits that are expected to occur in succeeding plans year, determined on the basis of average annual benefit increases over the previous six years.

In determining the maximum deductible amount, the value of plan assets is not reduced by any pre-funding balance or funding standard account carryover balance. The Pension Protection Act retains the present-law rule, under which, in the case of a single-employer plan covered by the PBGC that terminates during the year, the maximum deductible amount is generally not less than the amount needed to make the plan assets sufficient to fund benefit liabilities as defined for purposes of the PBGC termination insurance program.

In determining the cushion amount for a plan with 100 or fewer participants, a plan’s funding target does not include the liability attributable to benefit increases for highly compensated employees resulting from a plan amendment that is made or becomes effective, whichever is later, within the last two years. (The small plan must be careful concerning this provision.)

The rules relating to projecting compensation for future years are intended solely to enable employers to reduce volatility in pension contributions; the rules are not intended to create any inference that employees have any protected interest with respect to such projected increases.

The Bankruptcy Act of 2005

The Bankruptcy Act of 2005 allows funds held in a qualified plan to be exempt from claims of creditors for the bankruptcy estate. The Bankruptcy Code states:

(A) If the retirement funds are in a retirement fund that has received a favorable determination under section 7805 of the Internal Revenue Code of 1986, and that determination is in effect as of the date of the filing of the petition in a case under this title, those funds shall be presumed to be exempt from the estate.

(B) If the retirement funds are in a retirement fund that has not received a favorable determination under such section 7805, those funds are exempt from the estate if the debtor demonstrates that:
    (i) no prior determination to the contrary has been made by a court or the Internal Revenue Service; and

    (ii) (I) the retirement fund is in substantial compliance with the applicable requirements of the Internal Revenue Code of 1986; or (II) the retirement fund fails to be in substantial compliance with the applicable requirements of the Internal Revenue Code of 1986 and the debtor is not materially responsible for that failure.
(C) A direct transfer of retirement funds from one fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code of 1986, under section 401(a)(31) of the Internal Revenue Code of 1986, or otherwise, shall not cease to qualify for exemption under paragraph (3)(C) or subsection (d)(12) by reason of such direct transfer.
(D) (i) Any distribution that qualifies as an eligible rollover distribution within the meaning of section 402(c) of the Internal Revenue Code of 1986 or that is described in clause

(ii) shall not cease to qualify for exemption under paragraph (3)(C) or subsection (d)(12) by reason of such distribution.

(iii) A distribution described in this clause is an amount that--
    (I) has been distributed from a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code of 1986; and

    (II) to the extent allowed by law, is deposited in such a fund or account not later than 60 days after the distribution of such amount.
Worksheet

LoanPension +PSTax@35% Interest Total tax refund
$250,000 $250,000 87,500 12,46799,967
$150,000 $250,000 87,500 12,467 99,967
$100,000 $100,000 35,00012,46747,467
-0- 47,46716,61312,467 29,080
-0-29,080 10,17812,46722,645


Pension asset @3%:

257,500 EY1
522,725 EY2
641,406 EY3
709,539 EY4
760,777 EY5

Loan amount $388,780

Pension assets @5%

262,500 EY1
538,125 EY2
670,031 EY3
739,931 EY4
807,461 EY5

Loan amount $388,780
Pages: 1234
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