Three common mistakes business owners make
by Carey YukichMs. Yukich is a Registered Representative and Investment Adviser Representative of Equity Services, Inc. Securities and investment advisory services are offered solely by Equity Services, Inc., Member FINRA/SIPC, 123 N. Wacker Drive, Suite 600, Chicago, IL 60606, (312) 236-2500. TrueWealth Advising Group is independent of Equity Services, Inc.
When working with business owners, the financial adviser’s fundamental and vital role is to provide guidance in risk management while facilitating a viable strategic plan and encouraging the client to seek balance in their business, personal and financial lives. Many business owners have trusted financial advisors, but are they strategically protecting their personal and business assets?
MISTAKE #1 – Putting or Retaining All of Your Assets in Your Business
New business owners or sole proprietors often use their personal assets to assist with the startup of their business or the stabilization of business working capital. This can be dangerous if not done correctly. Continually retaining a large portion of personal wealth in your business causes a lack of financial diversification and can leave your assets at risk. Designing an appropriate, defined corporate business structure can provide the owner with protection of their personal assets. It is vital for business owners to build retirement assets outside of the business because at some point they may not have income from the business or the business may not remain viable for a sale down the road. Non-qualified investments help supplement this need. Instituting strategic financial planning techniques can provide diversification of capital as well as risk.
Solution #1 – ERISA-Qualified Retirement Plans
ERISA-qualified retirement plans include 401(k)s, SEP, SIMPLE IRA, profit sharing and deferred compensation plans. These plans offer some protection from creditors, especially if they are attached as marital assets during a divorce proceeding (i.e., QDRO) or a child support situation. Additional employee benefits such as Heath Savings Accounts(s) may also be protected if they are qualified ERISA accounts. If you are facing tax debts from the IRS, criminal fines or unethical use of the plan, these protections also may no longer qualify. The benefit of qualified retirement plans set up under the Employee Retirement Income Security Act (ERISA) is some protection from legal judgment stemming from lawsuits or bankruptcy in the business and diversification of owner assets.
Solution #2 – Non-Qualified Deferred Compensation Programs
Highly-compensated business owners and their top executives are generally not able to contribute the same proportion of their earnings to traditional qualified retirement plans. They may receive a portion of their compensation and benefits in the form of non-qualified deferred compensation programs such as SERPs (Supplemental Executive Retirement Plans), Executive Bonus Plans funded with life insurance or phantom stock plans. These plans defer a specific supplemental portion of the owners’ or key employees’ salary to a later date (i.e., retirement) and defer income taxes on that money until the year the compensation is received by the employee. These plans may offer the additional benefit of receiving these funds earlier in the event of a premature death or disability. The nature of these plans and how they are strategically funded typically makes them unavailable to creditors, because the owner and employee do not have legal ownership of the benefits until they are distributed. However, much like their qualified counterparts, these plans do not offer full protection from all creditors, specifically if they are attached as marital assets during a divorce proceeding (i.e., QDRO), as one example.
Solution #3 – Non-Qualified Investments
Non-qualified investments are savings vehicles funded with after-tax dollars and generally do not qualify for tax-exempt or tax-deferred status. They are not always readily liquid but often provide a means to keep business and personal assets separate. Examples of non-qualified investments include stocks, bonds, real estate investment trusts (REITs) and non-qualified annuities. In addition to providing retirement income, many non-qualified annuities offer existing or optional features that can provide a business owner valuable benefits, such as no income contribution limits, principal protection and benefits to beneficiaries. Annuities may also offer benefits to assist or supplement long-term care needs or disability income benefits.
MISTAKE #2 – Lack of a Formal Succession Plan
Many business owners have not instituted a formal written succession plan for their business. They may feel creating a plan is unimportant, overwhelming or too complex. Fear of creating conflict within the family or organization as well as a reluctance to even consider this transition are roadblocks to the process. The risk of procrastination is the untimely occurrence of a severe or long-term illness, disability or a premature death. An unfortunate event such as any of these could create insurmountable debt to keep the business going or could cause the foreclosure of the business if specific, named individuals, are not responsible for daily business decisions and sales operations. With proper guidance, strategic planning techniques can be implemented to assist business owners in contemplating these important decisions and codifying their desires in writing. Whereas a business owner might feel they have a successor in mind, without a written succession plan, upheaval is certain to occur in the event of a transition event. Decision making in the heat of a crisis does not typically result in a valuable or acceptable outcome.
Solution – Written and Funded Buy / Sell Agreements & Key Employee Benefits
Two primary planning techniques include a written and funded buy / sell agreement using life and disability insurance, and a structured key employee benefit program. A formal buy / sell agreement along, with a succession plan, helps to clearly designate your desires in writing in order that a formal strategy is in place to assist with legal, tax and financial matters during a succession. Key employee benefits help to retain key leaders in your organization should an unforeseen event transpire involving the business ownership or leadership. Instituting any or all of the aforementioned strategic planning concepts will help position your business to persevere and thrive in times of transition.
MISTAKE #3 – Lack of Tax Efficient Planning
Several of the concepts mentioned above not only provide strategic benefits to the business; but, may also assist in tax efficient financial planning. Business owners often pay less to themselves early on attempting to minimize income tax exposure, not realizing they may be able to direct assets to a qualified retirement plan for retirement or for other future goals. During years of declining revenues or loss, it may not always be possible to contribute to these plans regularly, but it is imperative to contribute a certain amount each year to minimize personal income tax exposure and to fund your retirement. You don’t want to risk your future on the hopes that your business will someday be wildly successful, and the sale of it will fund your retirement objectives. Hope should never be considered a plan.
Life insurance, disability insurance and long-term care programs purchased using business dollars may also afford the opportunity to protect the financial security of your family, while potentially qualifying as a business deduction if structured properly. Insurance premiums paid to fund buy / sell agreements as well as to fund business continuation strategies may also be tax-deductible to the business and can help protect not only your family, but also the long-term viability of the business.
Key executives in your business, identified as your successors or deemed vital to the health of the business, are often restricted from fully maximizing traditional retirement savings plans due to income or contribution limits. Various non-qualified compensation strategies that use life insurance for funding can provide additional compensation to these employees and may also offer tax efficient benefits to the owner. The owners have the ability to select who they want to receive these benefits on a non-restricted basis. Life insurance-funded compensation plans allow the owner to deduct the cost of the premiums, or their tax-qualified matching contributions for that year, assuming the compensation paid to the employees is within specified parameters. The premiums paid by the business owners are considered income to the employee in the year they are paid, but the owner can also reimburse the employee for this income through tax matching contributions. The death benefit paid to the employees’ beneficiary(s) are generally considered tax free just like any life insurance policy. Note: loans taken from the cash value of the policy may be taxable to the employee. These types of strategies can help avoid the income qualification requirements that generally apply to other types of retirement plans for both the owner and the executive.
Succession planning is only one key piece of the estate planning strategy. A properly integrated estate plan focuses on structuring your personal, family and business assets so that they may be passed on in a tax efficient manner according to your wishes. Succession planning prepares you for a change in business ownership while estate planning positions you for the tax efficient and orderly transfer of your assets and desires for legacy planning. Both types of planning make use of legal, tax, insurance and financial planning techniques along with trust planning strategies as required. Planning may also facilitate the all-important conversations that need to occur with your family, loved ones and business relationships.
Planning for the growth and future viability of your business can be a challenging process. Having a proper understanding of the opportunities available to help prevent common mistakes, such as those listed above, are vital to your financial security. Financial strategies can be devised to help balance the competing demands on your business, protect your personal finances, help minimize tax exposure and assist in passing down your assets to those whom you desire. ◊