With tax reform being a major part of President Trump’s platform and with both houses controlled by the Republicans, many are wondering, “How will the tax environment change?” Most professionals in the financial services industry will be asked about this hot topic because it directly impacts the financial plans of our business clients. The follow up question will nearly always revolve around whether a client should pay tax now, later, or some combination thereof.
The answers to these questions will usually be determined by the client’s specific fact situation. In the cases I see there are three common fact patterns for small businesses and professional practitioners.
The first is the professional doctor, lawyer, and consultant. In many states these professionals are losing fifty cents on every dollar they earn to federal and state income taxes under current law. Keeping dollars lost to taxation and preserving growth opportunities for these funds is paramount. Potential solutions for these clients are often overlooked due to advisor concerns about complexity and marketing support. With the right advanced markets support at your IMO these concerns fade away. There are three commonly accepted solutions for these organizations.
The Solo K Plan that can provide deferrals up to $60,000 on a totally flexible basis from year to year; the focused or defined benefit plan which can take the form of a traditional defined benefit plan, funded with investments, annuities and life insurance; or a fully insured plan funded with guaranteed annuities and life insurance, a Sec. 412(e) plan. Tax deferrals for defined benefit plans can range from $175,000 to $375,000 depending on the age of the participant and the form of benefit chosen. Generally plans for older individuals with life insurance, disability, annuity payout provisions offer higher deferrals. Lastly, a premium finance solution could provide needed protection and tax advantaged growth and income while potentially allowing a substantial deduction for interest payments paid by the company. This type of organization is definitely in the pay tax later regime.
Individually Owned Businesses
The second example would be successful small businesses with more than six employees that are owned by one individual or a family. These businesses are usually moderately to very successful. The overriding need of this type of business is to protect the owner’s family from loss of earnings in the event of death, disability or retirement. The secondary concern is a succession plan for the business to help reduce loss in value due to liquidation and insure that the employees are not put on the street at the owner’s demise. The statistics are pretty dismal. 70 percent, 30 percent, and 12 percent are the success rates in the first, second, and third generation. An ideal way promote continuity in these individually owned businesses is with a one way buy-sell agreement. This type of agreement is evidenced by a contract specifying a key person in the business who has the ability to take over reins of control. The contract states that the employee will purchase the business at a specific price or a price determined by an appropriate formula. This type of arrangement can take several forms. Often, surprisingly enough, it is merely an installment sale agreement to take place at some future date hopefully funded by distributions from company profits. This approach is rarely successful and in my experience poses the greatest risk of failure. A more favorable approach is a modified installment sale or one way buyout agreement. The modified installment sale is usually structured as an entity plan. This approach provides added protection because the funding is controlled by the company. It also requires that the key employee be brought into the business at an early date. This can be an advantage, however, because it gives the employee the incentive needed to stay the course. The one way buy out on the other hand relies on the agreement but provides the employee with financial power to complete the agreement. Funding is critical, otherwise the owner can’t be sure of getting the full value of the business which defeats the whole purpose of the agreement. At least 50 percent of all business succession plans remain unfunded. The business owner needs to make sure that enough money is gained from the sale to help fund retirement or provide for family in the event of death or disability. Although funding alternatives like sinking funds or an investment portfolio are possible, permanent life insurance provides a solution that completes from day one, builds cash value with a powerful growth engine on a tax deferred basis and supplies tax free cash at retirement or death. Typically, the plans are set up so the business would cover the cost of the premiums for this policy in the form of loans or bonuses to the successor. You can also set it up so that the successor covers a portion or the full cost of the premiums. This group is more tax neutral. While taxation is still a concern, it is not the overriding concern that it was for the professional group.
Lastly, there are larger firms with a larger number of employees and multiple ownership interests. These entities can take any business form—pass through like Subchapter “S” corporations and LLCs or separate tax entities like “C” corporations. They typically have health plans and a 401(k) plan. Retirement plans for rank and file employees often benefit key employees marginally. Surprisingly, many of these larger companies may not have adequate succession plans. They are also the best candidates for executive bonus, key person, split dollar, and deferred compensation plans. For this type of company there may be a strong interest in paying tax now as key executives are likely to be in relatively high tax brackets during retirement. Tax on the seed beats tax on the harvest when you are looking for the most efficiency in retirement income planning.
All of the above conclusions assume current tax rules. But what if the current administration is successful in implementing its proposed changes? On the individual side we might see lower tax rates of 12 percent, 25 percent, and 33 percent, with fewer deductions and higher personal exemptions. On the business side we might see a significant reduction in tax rates. Corporate rates could be reduced from 35 percent to 20 percent. The tax rate for pass through entities could be reduced from 40 percent to 25 percent. Some business benefits may be lost, primary among them is the business interest deduction.1 The professionals we discussed would be most impacted by these changes. The pressure for current deductions would be less than under current rules. Qualified plans that focus on current tax benefits may be less attractive versus Roth or life insurance driven concepts. The loss of the interest deduction could impact the attractiveness of premium finance versus traditional short pay minimum non-MEC cash building solutions. With respect to individually owned businesses, the net after tax cost of developing succession plans could be lower. Also, for larger firms, the net after tax cost of funding succession and various executive compensation plans could be less. It appears that if the administration’s proposals are implemented, potential solutions using life insurance would only be more attractive.
I do not have a crystal ball, and the outcome of this administration’s push for tax reform is uncertain at best. However, I do know that with generations passing the baton, American businesses need the help of insurance professionals and their supporting marketing organizations more than ever. Businesses need our help to avoid unnecessary financial loss at the death, disability or retirement of owners and key employees. We have important work to do.
1. Deloitte, 2017 Essential Tax and Wealth Planning Guide, Post-election tax policy update—Impact of the 2016 elections, Installment Two.
For agent use only. Not for use with the public. The tax and estate planning information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Partners Advantage does not provide legal or tax advice. Partners Advantage cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Partners Advantage does not assume any obligation to inform you of any subsequent changes in the tax law or other factors that could affect the information contained herein. Partners Advantage makes no warranties with regard to such information or results obtained by its use. Partners Advantage disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.
William H. Jackson
JD, CLU is the senior advanced markets consultant at Partners Advantage, working with all divisions of the company to assist financial professionals and agencies in growing their businesses. He provides his valuable strategies on a number of areas, including tax, financial, philanthropic, retirement, business and estate issues. He is part of an in-house team of highly experienced professionals at Partners Advantage which provides insights on complex cases and products. These services also include an in-house underwriting team and compliance and suitability team. Prior to joining Partners Advantage, Jackson served in a number of sales and product marketing roles at Sun Life and AIG Sun America. Jackson also has extensive experience managing pension, business and estate planning, and deferred compensation divisions. Jackson may be reached via email at: firstname.lastname@example.org.