Cash balance plans can serve a multitude of purposes in partnerships and similar firms. We traditionally see them as retirement tools that allow shareholders to make very large tax-deductible retirement contributions while at the same time providing meaningful benefits to their employees. In this standard scenario, each individual partner is generally responsible for funding their own benefit.
However, a recent article highlights another way to harness the power of a cash balance plan: By using it as a tax-efficient way for older shareholders of a professional practice to sell their stake of the business to young owners. The article uses the example of a business owner (Founder) who wants M as payment for his share of the business. In a traditional sale situation, the remaining young partners (Youngsters) would have come up with M of after-tax dollars to be paid to the Founder, and the Founder would then have to pay capital gains taxes on the proceeds.
In an alternative scenario, a cash balance plan is set up such that the Founder’s projected benefit from the plan is M in his year of retirement. Then, in the remaining years between plan inception and the Founder’s retirement date, the Youngsters are responsible for contributing the money necessary to fund the Founder’s benefits. Because this is a qualified retirement plan, the contributions are tax-deductible for the Youngsters and the benefits are tax-deferred for the Founder.
The article goes on to provide some additional details, but I’d like to offer other points to consider:
- The business transition approach may be a great idea for some firms, but it should be noted that in this situation the Founder does not get the benefit of lowering their taxable income through tax-deductible cash balance contributions. This is because the Youngsters are funding the Founder’s benefit.
- The article mentions that each employee has their own individual account instead of “the vague promise of an ‘accrued benefit’ that may or may not be adequately funded”. I agree that each participant has a hypothetical account. However, this is a defined benefit plan so it can become underfunded since benefits are guaranteed but asset values can fluctuate depending on asset performance and contribution levels.
- Some additional features that may be attractive to the Founder are the ERISA (and potentially PBGC) protections that come with a cash balance plan.
- The number of years until the Founder’s intended retirement is a key consideration. There needs to be adequate time for the Founder’s benefit to accrue and for the Youngsters to make the necessary contributions.
