Understanding Business Succession Chapter 18: NQDC Plans Can Make Succession Planning Easier

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1 Understanding Business Succession Chapter 18: NQDC Plans Can Make Succession Planning Easier This is the eighteenth in a series of articles which discuss how life insurance can be used in business succession planning. Be on the lookout for additional articles in the future. Business owners invest a great deal of time, money and emotion in their businesses. When it comes time to retire, they need to convert its value into cash that can fund a reasonable lifestyle. Many owners do that by selling the business. Once the owner finds a suitable buyer, an acceptable price and terms need to be set. Negotiating a mutually agreeable price and terms can be difficult. Because there are a number of valuation methods, a business value is subjective and hard to pin down. Buyers naturally want to pay as little as possible, while sellers want to receive as much as possible. They need to find an acceptable middle ground. In a perfect world, many sellers would like to cash out of their business immediately. Unfortunately, many buyers are key employees or younger family members who don t have the financial resources to pay for the business in a lump sum. Instead, most buyers come to the arrangement expecting the business to produce enough profits to make the purchase payments. Smart sellers try to structure the agreement as a win-win. They know that setting too high a price and too short a payment schedule can make it difficult (if not impossible) for the buyer complete his/her side of the bargain. They also know they may need to have some flexibility in the event the buyer experiences difficulties because of changes in the market or in business conditions. If the buyer can t make the payments, the seller could wind up getting the business back in far worse condition than when they initially sold it.

2 1 2 3 One way to add flexibility to a business succession plan is to include a non-qualified deferred compensation (NQDC) plan as part of the payment strategy. In a business succession context, a NQDC plan is a selective executive benefit for the selling owner. In it the business promises to pay the seller a series of installment payments after he/she retires. A NQDC plan can be useful when a business is going to be sold to a key employee or to one or more family members. It has the potential to add flexibility to a business succession arrangement in at least three ways: A NQDC Plan Is a Debt That Reduces a Business Value A NQDC benefit is an enforceable promise to make a series of future payments. As such, its present value is a liability on the business balance sheet that reduces its fair market value. Creates a Second Payment Stream The NQDC payments are separate and distinct from those which purchase the seller s ownership interest. They may be paid from either current business assets or expected future profits. If the business already has sufficient assets to fund the NQDC payments, it may not experience much financial strain as a result of the agreement. NQDC Payments Are Taxed Differently Including NQDC payments as part of a buy-out package is often advantageous for the buyer and the business because the NQDC payments are taxed as compensation. That means that when they are paid out, they are generally tax deductible to the business and taxable to the selling owner as ordinary income. Payments made to acquire the seller s stock or ownership interest, on the other hand, are generally not deductible to the business. To the extent payments for the stock exceed the selling owner s basis, the owner is taxed on the excess as a capital gain. Because NQDC payments are tax deductible, they are less expensive to the business than purchasing the selling owner s stock. An example involving a $10,000 payment can explain this point. If the $10,000 payment is paid to the seller as a NQDC benefit, the business can deduct it. Thus, if the business is in a 25% income tax bracket, its net after-tax cost of the $10,000 payment is $7,500. The $10,000 NQDC payment is fully taxable to the selling owner, so he/she nets $7,000 to spend after taxes (assuming a 30% marginal income tax bracket). If instead the $10,000 was a payment for the owner s stock, the business would have to earn $13,333 in profits so that after taxes it had $10,000 remaining to make the payment. If the owner has a $1,000 basis in that stock, he/she has a $9,000 long-term capital gain. Assuming a 15% capital gains tax rate, he/she nets $8,650 after taxes.

3 There are usually two different types of business buyers: key employees and family members working in the business. A NQDC benefit may add flexibility to each of these succession scenarios. 1 2 Key Employee Succession In this scenario, a non-family key employee agrees to purchase the business and buy out the retiring owner. The key employee usually has substantial experience in the business and is familiar with the business customers and other employees. Let s consider the situation of Dan DuPuy, the owner of Dirty Dan s Diabolical Distillery (DDDD), a C corporation. An appraisal two years ago valued the business at $1,000,000. Dan is 68 and wants to sell his interest when he reaches age 70. His key employee is Bob Best, age 50, who has been with Dan for over 20 years. Dan wants to take over the business, but doesn t have any significant capital of his own. He thinks he can run the business well enough to produce the profits needed to buy it, but his appraiser told him that its value is closer to $750,000 than $1,000,000. After some hard bargaining, Dan and Bob reach an agreement. Dan agrees to sell his interest to Bob by giving Dan two separate payment streams. Bob will buy DDDD from Dan for $600,000 on Dan s 70th birthday. Bob will make a $100,000 down payment and pay the remaining $500,000 in five annual installments of $100,000 plus interest on the unpaid balance. As part of the deal, Dan will continue working for DDDD during the payment period as chairman of the Board of Directors. Bob will be president and handle DDDD s day-to-day operations. For his ongoing service, Dan will receive a NQDC benefit consisting of an annual payment of $50,000 for 5 years beginning at age 75 (after Bob s buy-out payments end). Thus, Dan will be paid a total of $850,000 over a 10 year period. Family Succession Let s change one fact in Dan Dupuy s DDDD scenario: Bob is Dan s son. Dan wants to keep the business in the family and will transition ownership to Bob when he retires. To keep the business profitable and in the family, Dan is willing to give Bob better terms than he would give to a non-family member. Of course, that assumes Dan can receive funds from the business to maintain his financial security after he leaves the business. He is willing to sell 75% of his interest to Bob starting in two years at age 70. During the payment period he will be Chairman of the Board and Bob will become president with responsibility for day-to-day operations. The payments will be nothing down and $70,000 per year for five years; interest on the unpaid balance will be due annually. He plans to transfer the remaining 25% to Bob at his death through a bequest in his will. But Dan still needs supplemental income when he retires. So the business will pay him a NQDC benefit of $100,000 per year for 5 years beginning at age 75 when he leaves his position as Chairman. Dan will receive $850,000 in combined payments over the 10 year period. If he needs additional money later, he may be able to sell his remaining 25% interest to either Bob or the corporation.

4 To NQDC or Not To NQDC? The NQDC payments could act like a salary continuation agreement in which the business will continue to pay the departing owner s salary for a series of years after he/she retires. ly, they are less valuable to a selling owner than payments for stock or other ownership interests because of the manner in which owners are taxed on NQDC benefits. Still, there may be some other considerations which may offset this disadvantage: ď ď The NQDC plan can earmark specific business assets to pay the promised benefits. Those assets can be moved into a separate entity known as a Rabbi Trust. Although assets moved into this trust are still business assets, putting them into a trust may provide an additional layer of protection for the seller and increase the likelihood that the NQDC benefits will be paid. The trustee is responsible for overseeing these assets to make sure they aren t put at risk in day-to-day business operations. ďď ďď ďď The NQDC benefit makes the selling owner a general creditor of the business and gives him the right to receive business assets if the business defaults on the NQDC payments. Incorporating a NQDC benefit into the succession strategy can make a big difference in reaching a purchase agreement. The tax deductibility of the NQDC payments can be a critical factor in the seller s ability to make the promised payments. The difference between having enough revenue to fund a $10,000 stock purchase instead of a $10,000 NQDC benefit can be amazing. The DDDD example shows that it takes $7,500 of revenue to fund a $10,000 NQDC benefit while $13,333 is required to fund a $10,000 stock purchase payment. If DDDD has a profit margin of 10% on each dollar of sales, it will need $75,000 in revenue to pay a $10,000 NQDC benefit and $133,333 in revenue to fund a $10,000 stock purchase payment. If the NQDC payments are made after the selling owner has retired, he/she may be in a lower income tax bracket and the taxes due on the benefit payment could be lower. the NQDC Payments with Cash Value A NQDC benefit is a promise to pay future benefits. Savvy sellers want to make sure the company sets aside sufficient liquid or semi-liquid assets to make the NQDC payments. This is true whether they live long enough to receive all the promised benefits or die before all the benefits have been paid. Cash value life insurance is often used to fund NQDC benefits. This is true for several reasons: 1. Policy cash values grow income tax deferred and may be used as a source of funds to pay all or part of Dan s NQDC benefit (it may take several years of adequate funding for policy cash values to become large enough to provide a funding source for the benefit). A Voya Life Companies cash value life insurance policy (e.g. Voya IUL-Global Choice, issued by Security Life of Denver Insurance Company) may help provide life insurance flexibility. 2. If Dan dies before the all his stock and NQDC payments have been made, DDDD must still make the remaining payments; death proceeds from a life insurance policy can provide all or part of the funds DDDD will need to pay the remaining balance. 3. Policy death benefits are often income tax free to the company under IRC Section 101 (it is possible, however, that policy cash values or death benefits may be subject to the corporate alternative minimum tax on C corporations). 4. If Dan receives all the NQDC benefits promised, DDDD can retain the policy and use its death benefits to recover all or part of the cost of the stock and NQDC payments it made to Dan. 5. Policy death benefits could also potentially be used to fund a NQDC payment for Bob if and when he decides to retire from DDDD.

5 Additional There are some things Dan and Bob should consider before adding an NQDC benefit to their business succession arrangement: Be Careful Before Revising NQDC Benefits Accelerating NQDC benefits may trigger tax penalties if the change takes place less than 5 years before the benefit is originally scheduled to be paid. The person receiving the benefits (in our example, that s Dan) is responsible for paying the resulting taxes and a 20% penalty. If NQDC benefits are going to be postponed, they should be delayed so as not to begin within five years of the new initial payment date. If payments begin before then, Dan could again be responsible for additional taxes and penalties. NQDC Benefits Must Be Reasonable The NQDC benefit payments are only deductible if the employee s total compensation (including NQDC benefits) is reasonable. If the selling owner s total compensation package is unreasonable, the IRS will deny DDDD a deduction for the NQDC payments. NQDC Benefits Must Not Be a Disguised Dividend Historically, the IRS has challenged NQDC benefits for owners that it believes are a ruse for taking money out of the business without declaring and paying a dividend. When the owner is the only employee receiving the benefit, the potential for an IRS challenge increases. It could disallow the corporation s income tax deduction for the NQDC payments and treat them as dividends. A potential strategy for avoiding dividend treatment is to couple the owner s NQDC benefit with a separate NQDC benefit for the purchasing key employee and other key employees. These extra NQDC benefits will likely be paid well after the sale has been completed and the owner has left the business. They can be funded with cash value insurance or even with term insurance. Pass Through Tax Entities Owners of businesses organized as pass through tax entities (S corporations, LLCs, LLPs, PLLPs, etc.) are taxed on their business profits annually regardless of whether they take a distribution of their share of the profits. Because NQDC benefits are compensation payments from the business, they will be taxable to owners. Thus, it is probably not wise to use business assets that have already been taxed to make the NQDC payments. Instead, it might be better to pay the NQDC benefits out of cash flow the business generates during the year the payment is made. If this strategy does not offer the owner enough certainty, it may make sense to avoid using NQDC benefits altogether.

6 Conclusion In a number of cases, it can make sense to include NQDC benefits as a business succession planning strategy. These benefits can increase planning flexibility and reduce the after-tax cost to the buyer. They can create a second payment stream for a selling owner and reduce the amount of revenue the buyer may need to generate to make the payments required under the agreement. Cash value life insurance can help fund a NQDC benefit so it is backed up by money. A life insurance funded NQDC benefit can make a big difference in creating a workable business succession plan. The Voya Life Companies have created a platform to help make Business Succession sales easier for you. To learn more, access the Business Planning Microsite at or Voya for Professionals at voyaprofessionals.com or try any of the following introductory materials: Buy-Sell Planning Producer Guide (#117671) Buy-Sell Planning Consumer Overview brochure (#117672) For more information on business succession planning, contact your Voya Life Companies Representative or call Sales at , Option 4. These materials are not intended to and cannot be used to avoid tax penalties and they were prepared to support the promotion or marketing of the matters addressed in this document. Each taxpayer should seek advice from an independent tax advisor. The Voya Life Companies and their agents and representatives do not give tax or legal advice. This information is general in nature and not comprehensive, the applicable laws may change and the strategies suggested may not be suitable for everyone. Clients should seek advice from their tax and legal advisors regarding their individual situation. Life insurance products are issued by ReliaStar Company (Minneapolis, MN), ReliaStar Company of New York (Woodbury, NY) and Security Life of Denver Insurance Company (Denver, CO). Within the state of New York, only ReliaStar Company of New York is admitted and its products issued. All are members of the Voya family of companies Voya Services Company. All rights reserved. CN /01/2014 Voya.com