Planning for Retirement: Crafting a Vision for Golden Years
At some point, whether driven by desire or necessity, every family business owner has to think about making room for the next generation. But in a family-owned business, retirement isn’t just a matter of deciding not to go into the office anymore. Besides ensuring that the business owner has enough money to retire comfortably, the whole question of what happens to the business becomes paramount. Who will manage the business? How will the ownership transfer occur? Should the business carry on or should it be sold?
Why Not Just Give the Business to Heirs?
At some point, whether driven by desire or necessity, every family business owner has to think about making room for the next generation. Many business owners would like to simply give the company they led for years (and perhaps founded) to a dedicated son or daughter when they are ready to retire. However, most have not accumulated sufficient assets outside of the business to retire comfortably without selling their primary asset—the business.
Although a sale is necessary for the older generation, often the younger generation doesn’t have the money to purchase the business outright. What can a business owner do? There are options that allow the business owner to transfer the business on a tax-favored basis while securing supplementary retirement income.
One of the most popular methods is an installment sale or self-canceling installment note, in which the business owner transfers the business to a family member in exchange for a promissory note. This allows the child to buy the business by making payments over time, often from revenue generated by the business.
Unfortunately, because the payments must be low enough that they don’t create a hardship for the child or the business, they may not be enough to support the retiring owner.
When an installment sale is the best way to transfer the business interest, business owners often purchase life insurance on the buyer’s life. This protects the retiree’s income by ensuring that the retiree receives payment even if something unexpected happens to the successor before the installment sale is complete.
A private annuity is another alternative. With a private annuity, the owner transfers ownership of the business to a family member. In exchange, the family member enters into a contract promising to make periodic payments to the owner for the remainder of the owner’s life (single life annuity) or for the owner’s life and the life of a second person, such as the owner’s spouse (a joint and survivor annuity). The child or other family member can then make these payments using income generated by the business.
Proper business valuation is essential. The buyer takes the risk that the owner will live beyond normal life expectancy, which would increase the purchase price. Because the annuity payments are unsecured, the owner also takes a risk—after all, it’s possible the buyer may, at some point, become unable to make the ongoing payments.
GRAT or GRUT
Instead of an outright sale, a business owner can transfer a business interest over time using a grantor-retained annuity trust (GRAT) or grantor-retained unit trust (GRUT). These are irrevocable trusts that can provide an annual income payment to the retiring owner for a set period of time. At the end of the trust term, the trust assets (in this case, the business interest) will transfer to the named beneficiaries with little or no gift tax, despite any additional growth in the value of the business.
The main difference between GRATs and GRUTs is in the income the trust provides to the grantor (the business owner). In a GRAT, the income interest is a set dollar amount or a percentage of the value of the assets originally transferred to the trust. In a GRUT, the income interest is a fixed percentage of the trust assets as revalued every year.
FLP or FLLC
The form of the business can play a role in how the business is transferred to the next generation. Converting a family business to a family limited partnership (FLP) or family limited liability company (FLLC) lets an owner transfer ownership of the business to family members over time on a tax-favored basis. The owner can make annual gifts of partial ownership to family members while retaining management control. Gifts qualify for the annual gift tax exclusion and valuation discounts (since they lack marketability and control).
FLPs and FLLCs are useful for:
- preserving and transferring wealth
- limiting gift and estate taxes
- providing overall planning flexibility
- protecting assets
Supplementing Retirement Income with Life Insurance
As you know, cash-value life insurance has many uses. Life insurance loans and withdrawals can play an important role in supplementing existing sources of retirement income. Let’s review all the benefits life insurance can provide to a Baby Boomer business owner:
- Tax-deferred growth. Life insurance offers an opportunity outside of qualified retirement plans for business owners to enjoy tax-deferred growth over many years since no current income tax is due on cash value growth.
- Tax-free withdrawals. With life insurance, income opportunities are available through partial withdrawals, which are generally not taxed until the cash value withdrawn exceeds the total amount of premiums paid. Of course, withdrawals reduce the death benefit and the cash available to pay for the cost of insurance.
- Tax-free loans. Generally, loans are not taxable. Loans are subject to interest charges and they reduce the death benefit paid to beneficiaries.
- Flexibility. A policyholder can take withdrawals prior to age 59½.
- No required distributions. Unlike qualified retirement plans, life insurance is not subject to required minimum distributions at age 73.