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Get Personal with Business – The best Strategies for managing a business owner’s finances just might apply to his business, too.
By: Patrick J. Horan, September 2002
Adding value for clients has become something of a mantra as performance results suffer. The current market downturn gives advisers a perfect opportunity to offer clients something they really need – a combination of business and investment management planning to help business owners save money, cut costs and improve the chances for achievement of business and personal financial goals.
Plans for a business and plans for the owner are tightly bound together and require close coordination. The benefits can accrue not only to the owner but to his employees as well.
The truth is, most prospects who own businesses substantial assets also need outside consultants for vision, strategy and business planning to be able to keep their heads up while they navigate a difficult economy. The adviser’s goal should be to accelerate as much business expense as possible onto the business tad return while providing the additional personal planning benefits at no charge.
Of course, advisers should know what they don’t know: Business planning necessitates a serious effort on the part of the adviser to find appropriate types of consultants and invite their participation. The client ends up with an advisory board, and the adviser has a firm hand on what is happening financially – in the business and the client’s personal life.
There may even be a tax break. For the most part, fees pertaining to business planning, tax preparation and qualified plan design and management are deductible to the business owner, and an individual may deduct investment management and tax preparation fees on their schedule A, subject to 2% of adjusted gross income (AGI) limitations.
However, business owners are generally not subject to these floors. Therefore, there is opportunity to deliver services that are in fact tax deductible to the business owner and then provide ancillary personal financial planning services at no additional charge. A fee-only adviser in particular, who may have flexibility for how and when fees are charged, may be in the best position to deliver these services in this format.
Consider the following example:
Robert Smith is a business owner, age 45, and is approximately 17 years from retirement at the age of 62. his manufacturing concern has 80 employees, and the profit-sharing plan has $1.8 million in assets. Smith himself has personal investment assets of $750,000 outside this plan.
Smith manages the company’s profit-sharing plan using mutual funds. Of the $1.8 million in the plan, 55% ($990,000) belongs to Smith. The mutual funds are no-load and the expense ratio for the entire portfolio of mutual funds in the plan is 1.28%, or $23,040 annually. These expenses are being paid out of the plan assets (meaning less money for plan participants at retirement) and out of Smith’s personal investment portfolio.
This personal portfolio is a combination of mutual funds and a few individual stocks. The expense ratio for his personal investments is 1.62% annually including the costs for stock trades. Therefore, the total cost for investment management is $39,078 on $2,550,000 of assets, or 1.53%. Smith did not have any business or financial planning advice.
We provided evaluation and recommendations to help Smith reduce his fiduciary risk and tremendous liability in the profit-sharing plan by adopting an investment policy statement that specifically addressed the goals, objectives and investment constraints of the profit-sharing plan. This put Smith in compliance with federal pension law.
We encouraged Smith to raise profit sharing pre-tax contributions to 25% (previously 15%) under the 2001 Tax Relief Act. We provided – but did not bill for directly – retirement planning (services such as financial projections, what-if scenarios), education planning for his two children and estate planning suggestions to reduce his taxable estate.
The management fees for the profit-sharing plan were paid outside the plan with before-tax business dollars. Smith received a deduction fro his personal tax return for management fees paid (subject to a 2% AGI limitation) for his personal, taxable investment account.
Total after-tax expenses for professional money management of both the profit-sharing plan and Smith’s personal account were reduced to 95 basis points (gross fee to the planning firm) or $16,138 – which is 63 basis points annually on an after-tax basis. This represents and annual savings of $22,940 based on the current value of $2.55 million, while providing Smith with tax, investment, retirement and business financial planning.
Of course, trading costs are additional and will vary with portfolio size, market environment and investment objective. However, estimated trading costs (commissions to the custodians, such as Schwab) might run 5 to 12 basis points annually based on historical average for accounts this size.
Consider another example:
Jane Jones owns a company that applies industrial paint and coatings for the telecom and computer industries. She tends to have large cyclical contracts with large manufacturers. Jones has 250 full-time employees and the company is growing. It has a profit-sharing plan with $480,000 in assets.
Jones was making money despite herself when we met. She was working 90 hours per week and enjoyed the fruits of her labor. She had no strategic direction for her company although she was an incredibly successful entrepreneur.
We convinced her that she needed assistance to organize her business plan more effectively so that she could meet her personal goals and objectives. Jones was so busy doing-doing-doing from a business standpoint that she never took the time to stand back to consider what retirement would look like or to visualize how to maximize productivity in her manufacturing plant.
We finally got Jones to sit down and asked her about her plans for retirement and for her business. We soon learned that Jones did not have any clear, definitive goals for her business or her personal life. We also determined that we could never deliver all of what this client really needed.
We developed an advisory board that could help her with “life planning,” that is, a group to bring her business and personal life together in terms of having a definitive game plan. The board comprised experts in their particular fields to provide advice and direction so that Jones could begin to set her mission and objectives.
The advisory board met for two years. A psychologist managed the meetings. The team consisted of the following individuals:
The investment manager/financial planner, who had instigated the team development and knew the most about the client’s financial situation;
An estate-planning attorney who was also a CPA;
An actuary; and
A tax attorney who understood U.S. and international trade law.
From time to time, various experts were hired for short periods to meet specific planning needs that arose during the board meetings.
During those two years, the advisory board met monthly for eight hours at a time. The goal was to help Jones realize she could lead a more balanced life by empowering others in her business to increase productivity and increase net profit margins. The entire business was reorganized into operating profit centers to allow for maximum productivity, and a business continuation or succession plan was implemented for a controlled sale of the business at Jones’s retirement.
Meanwhile, another manufacturing plant was built in Guadalajara, Mexico, to take advantage of lower distribution and labor costs. The advisory board was especially helpful here dealing with international tax laws, tax duties and the various other complex issues that developed.
Jones also implemented estate planning suggestions by moving fast-growing appreciable assets into family limited partnerships and other entities to help with estate tax planning. And overall, she became much more focused in her personal life with a clear vision of what she wanted to accomplish both in business and personally. Jones developed a plan to sell the business to key employees and her son in 12 years.
Jones also took another look at her profit-sharing plan. It was not meeting her needs; because of the low-income nature of the manufacturing employees, it did not motivate them. She “terminated” the profit-sharing plan and distributed the assets to the employees and herself, giving them the choice of rolling the proceeds into an IRA or taking the proceeds as a taxable distribution.
The succession plan outlined a buyout that was designed to result in capital gains taxation (maximum 18% - 20% long-term capital gains) versus ordinary income taxation from profit-sharing plan distributions in Jones’s retirement. The distributions to Jones from the succession plan would result in potential income tax savings of over $10 million by converting ordinary income into long-term capital gains.
Here’s how it works:
By prearranging the sale of the business to start in 12 years (an installment sale from company profits to be paid over 10 years), the income tax savings resulted from converting ordinary income taxation to capital gains. Assume Jones took out $50 million in profits (some of this salary) over her retirement years; the tax on this would be more than 40% (state and federal taxes), or $20 million. Convert the $50 million to capital gains and you save $10 million.
At the time this planning was done (four years ago) there was also a significant savings on estate tax, but now that may be less, because of estate tax repeal. However, the main advantage to Jones was that she was able to pay for the services of the advisory board - $450,000 in two years – with before-tax business dollars. And this board helped her develop a life plan that made her personal life more balanced and fulfilling by putting her business and financial affairs in order.
As time moves on, with fee compression and competitive pressures forcing financial planners and investment managers to offer greater value to their clients, smart advisers will deliver a wider range of services to their business-owner clients. Combining business and personal planning works for everyone.
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