Defined Benefit Plan and the Sale of a Business
It was a dark and stormy night when Snoopy the dog took a call from a potential client.
The client quickly told Snoopy that he had just sold his business and his accountant advised him to contact an actuary about setting up a defined benefit plan that would be funded through the proceeds from the sale of his business. After a couple of congratulatory barks, Snoopy handed the call off to Charlie the actuary to discuss setting up a defined benefit plan.
Okay, maybe it doesn’t really happen this way, but we all get calls from time to time from prospective clients who have just sold their business and think that they can use a defined benefit plan in a tax-advantaged manner. Of course, we also get similar calls from existing clients with a 401(k) plan that covers their employees, who tell us they just sold the business and all the employees now work for the buyer.
For our colleague Charlie, the first questions are likely to be:
- How much money is coming from the sale?
- How is it getting paid?
The second question might be modified depending on the answer to the first one, but essentially, Charlie will ask, “What type of entity was your business and did you sell the entity or the assets of the entity?” If this is an existing client, you should already know what type of entity operates the business.
The first question is one that separates the wannabees from the real clients. If the sale is for $100,000 and it is a one-time payment, it’s probably not worth the cost to set up and maintain a defined benefit plan for the time period needed to demonstrate that it was intended to be permanent.
The second question is more important. If the business was operated through a corporation (or an LLC taxed as a corporation) and the corporation was sold rather than the assets, the business and the corporation continue, just with new shareholders. The sale of stock will usually be a long-term capital gain to the seller; after the sale, the prior owner no longer has an operating entity that could sponsor a plan. If the prior owner agrees to provide consulting services to the buyer, then it is possible that the prior owner will now have a new sole proprietorship that will be receiving that consulting income, or he could set up a new entity solely for his consulting services.
This leaves you with two possibilities. First, the seller with no ongoing connection to the business doesn’t need a plan as there wouldn’t be a way to take the proceeds from the sale and contribute that money to a qualified plan — nor should he try and do so, since that would effectively be converting long-term capital gains income (taxed at a favorable rate) into a deferred income arrangement that ultimately pay the proceeds out as ordinary income at what is normally a much higher tax rate.
Second, the seller has an ongoing connection with the business, either as an employee or as an independent contractor. Again, the proceeds of the sale should not be used to fund a plan since it is poor tax planning even if some of those proceeds are funneled into the entity that is also receiving the consulting income. The new entity that is receiving the consulting income could sponsor a plan, but you have to be careful that the relationship between the new entity and the original business is not such that it creates an affiliated service group. Usually, a controlled group would not be a concern as long as both the original business and the new consulting entity did not operate at the same time with common ownership. Naturally, there are several variations of this type of arrangement, but they all usually lead back to the same questions and answers shown above.
The sale of stock is usually more advantageous to the seller, while the purchase of assets is usually more favorable to the buyer. With the sale of assets, the buyer gets to depreciate the assets purchased, making the purchase less expensive for the buyer, and the buyer does not have to assume any liabilities associated with the business prior to the purchase except as negotiated through the selling agreement.
The capital gains treatment for the seller when stock is sold is more favorable to the seller, and it also usually relieves the seller of any ongoing liabilities. So, why would a buyer ever do anything other than buy assets? Often, it has to do with favorable contractual arrangements where it is not possible to transfer those arrangements to a new entity. For example, the seller may hold a franchise for a certain territory with an old franchise fee agreement that only requires half of what a new franchisee might have to pay to the parent organization.
Since the sale of stock does not usually produce a scenario where a defined benefit plan might be beneficial, what about the sale of assets?
When there is a sale of assets, the original business entity still remains after the sale. For simplicity, this discussion will use a C-corporation as the original business entity and assume that post-sale there is only a single shareholder for the corporation. The C-corp enters into an agreement with NewCo to buy all of its assets, including customer lists and other business contracts. The day after the sale, all of the employees of the C-corp except the owner become employees of NewCo. As part of the sale agreement, the C-corp terminates its 401(k) plan immediately before closing. Thus, all of the employees can now participate in the NewCo 401(k) plan and also receive a distribution of their account balances from the C-corp 401(k) plan.
The C-corp now has only two assets and one employee. The two assets are cash from a large downpayment and a note receivable from NewCo payable over the next 5 years. Within the C-corp, some of the sale proceeds may be subject to capital gains taxes and the rest would be treated as ordinary income.
For purposes of this article, how the proceeds are taxed is not material, because there are only three ways to get the proceeds out of the C-corp and directly into the hands of the owner: pay the proceeds out as compensation, pay a dividend, or liquidate the corporation and distribute the corporate assets. What is inherent in the second and third options is double taxation, and the first option means the proceeds are taxed to the owner at ordinary income tax rates. With the second and third options, the assets get taxed at the corporate level and then again when received by the owner.
Of course, there is another indirect way to get the proceeds to the owner: through contributions to a defined benefit plan. At this point, you go back to question number one: is there enough money to make implementing a defined benefit plan worthwhile? In this case, let’s assume that the down payment is $500,000 and the annual payments over the next 5 years will be $250,000. In other words, there will be more than $1.5 million that could be used to pay compensation to the owner and make contributions to the new defined benefit plan.
Now, you have an owner who is currently the only employee and has lots of past service with a relatively high salary in those years. So, the plan design should be relatively easy to minimize current compensation and maximize contributions to the plan.
Well, sort of. Two things are critical in designing this plan. First, you don’t want to have the initial plan year overlap any period of time when there were other employees who would be covered. (Geez, sometimes those pesky coverage rules in 410(b) and 401(a)(26) just ruin all of the fun.)
Second, Treasury Reg. 1.401(a)(4)-5 says you can’t adopt a plan amendment that would discriminate in favor of highly compensated employees. It includes the following example.
Plan A is a defined benefit plan that covered both HCEs and NHCEs for most of its existence. The employer decides to wind up its business. In the process of ceasing operations, but at a time when the plan covers only HCEs, Plan A is amended to increase benefits and thereafter is terminated. The timing of this plan amendment has the effect of discriminating significantly in favor of HCEs.
But wait a minute; this is the adoption of an entirely new plan, not the amendment of an existing plan. Unfortunately, in the IRS’ view, adopting a new plan is the same as amending an existing plan. So, does this mean the C-corp should not adopt the plan? No, it just requires you to be cautious in designing the plan when it uses service and/or compensation over periods of time during which there were other employees at the C-corp.
Now, this is a good practice, but not necessarily the only option. You can rely on prior service and compensation when designing the plan, but you should advise the owner of the C-corp of the rules and that using prior service and compensation could be an issue if the plan is audited in the first two or three years after the sale.
Frankly, this is a business decision of trading off the advantages of a larger contribution and small current compensation with the risk that the IRS might audit the plan and identify this design as not in compliance with 1.401(a)(4)-5. Advising clients on audit risk is usually not a wise consulting assignment, and having ERISA counsel weigh in on the risks might be worthwhile if the amount of the contribution would result in significant tax liabilities if it is determined the plan is not qualified.
Here’s one last suggestion when it comes to implementing plans that will be using the proceeds of the sale of assets as the source of contributions: Choose either elapsed time to determine benefit service or an hours equivalency. Personally, I like to have the plan require 1,000 hours of service to accrue a benefit, but then set hours based on crediting 190 hours for any month in which an employee worked one hour. Usually, just opening the mail takes more than one hour a month, which means the owner will almost always meet the 1,000-hour rule for benefit accruals.
While there are certainly excellent arguments for not using past service and compensation for benefit accruals in such a plan — most of which are persuasive — ultimately, being able to substantially increase first-year funding for the plan may override the concern for any associated IRS audit risk. Even if the plan does get audited, it would take either a very experienced plan specialist or a manager overseeing the audit with prior experience in this area to identify the issue. Furthermore, the risk of this being an issue tends to decrease dramatically as you move down the road from the sale and away from the years in which the corporate tax return will show substantial amounts of compensation paid to non-officers.
Finally, the plan needs to have the appearance of being permanent. It is not good practice to design a plan that will only be around for a year or two. It certainly is helpful if the owner is actively seeking other opportunities for business, as that shows the plan could be viable beyond the 5 years or so while the proceeds of the sale are being received.