Can a Cash Balance Plan Fund a Succession Planning Strategy?

Welcome to the Retirement Learning Center’s (RLC) Case of the Week. Our ERISA consultants regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, Social Security and Medicare. This is where we highlight the most relevant topics affecting your business. A recent call with a financial advisor in Florida is representative of a common question on cash balance plans.

“Can a Cash Balance Plan Fund a Succession Planning Strategy?”

Highlights of the discussion

Please note: Any information provided here is for informational purposes only and does not constitute tax or legal advice. Individuals should consult with their tax advisor and/or attorney regarding their specific situation and needs.

A cash balance plan could be—under a very narrow set of circumstances—a tool to help with a business’s succession planning strategy.

Under this strategy, younger partners/owners buy out the senior partner/owner not with direct cash payments—which are not deductible—but rather, through making tax-deductible payments to a cash balance plan for the benefit of the senior partner/owner.

Thus, the theoretical advantage of this approach is to effect the buyout with tax-deductible dollars paid to the senior partner/owner via the cash balance plan.

Good theory. However, in our experience, business owners rarely utilize this strategy. Let’s explore why.

Frequently, the senior partner/owner wants to take less compensation and instead have most of his/her compensation paid as a tax-deductible cash balance contribution. The problem is that a large cash balance contribution is predicated on high compensation. Low compensation does not drive large cash balance contributions.

Next, expense allocation is prescribed within the partnership agreement and may be inconsistent with how the partners want the cash balance contribution expense to be allocated. The organization could compensate the senior partner/owner in fees for services and then allocate these fees as an expense to the organization. However, the IRS commonly challenges the deductibility of fee-for-service expenses.

In purchase transactions, common provisions in the buy/sell agreement may not be enforceable when using a qualified plan as the funding vehicle. To illustrate, if a senior partner/owner violates the terms of the agreement payments may not be recouped from a cash balance plan as such assets are not assignable and, except for the IRS, not accessible to creditors.

Conclusion

A cash balance plan can be utilized as a buyout tool for succession planning purposes.

A buy/sell transaction could be funded via a cash balance strategy, but such scenarios are not common. Organizations considering this approach should consult with their tax and legal advisors to determine if the cash balance strategy is viable in terms of the provisions of the partnership agreement, compensation levels and IRS requirements. For more information on cash balance plans, click here.