Let’s assume that you have a cash balance plan or another defined benefit plan, and you decide to sell your business. What happens next? Does the plan carry on to the new owner, or can you transfer it to a new company you own?
The answer depends on how the business sale is structured and your intensions. This post will discuss how business sales are structured and how these structures impact your retirement plan. Let’s get started!
Table of contents
There are two primary business sale structures:
- Asset purchase; or
- Stock purchase
There are pros and cons to the above structures. In general, the buyer wants to do an asset purchase, and the seller wants to do a stock sale. These diverging positions can make the negotiation process complex.
While there are many issues when negotiating these deals, it usually comes down to tax implications, current contractual relationships, liability exposure, and the strength of the brand of the existing business.
With an asset sale, the buyer is merely acquiring the company’s assets (and possibly the liabilities). They are not buying the company (stock or membership interests). So, in essence, the old company is dissolved or carries on in a limited capacity.
The buyer will usually set up a new company to hold the assets. If the buyer is already in business, they will typically merge the newly acquired assets into their existing business.
In an asset sale, the seller maintains the legal entity. The buyer simply acquires the individual assets, such as computers, fixtures, equipment, licenses, and inventory.
But most importantly, they acquire the goodwill and customer lists. In most service businesses, the value is in intangible items like goodwill and customer lists.
The significant advantage for the buyer is that with the asset purchase, the assets get a “step-up” in basis. The purchase price is then allocated to the purchased assets.
Equipment, computers, and other tangible assets are depreciated over their useful life, typically 3-7 years. The remaining purchase pricing is usually allocated to goodwill and other intangible assets with a 15-year useful life. As such, the depreciation expense for these items is a great benefit to the buyer.
In addition to the tax benefits, buyers like asset purchases because they more easily avoid potential liabilities, especially contingent liabilities relating to employees, product liabilities, contractual disputes, and other legal exposures.
However, asset purchases can present problems for buyers. Due to assignability, legal ownership, and third-party consent, contracts can be challenging to transfer. Obtaining consent and transferring contracts can slow the transaction process.
For sellers, asset sales can generate higher taxes. Intangible assets, such as goodwill will be taxed at capital gains rates. However, other tangible or “hard” assets are often subject to higher ordinary income tax rates.
If the selling entity is a C-corporation, the seller faces double taxation. It is taxed upon the initial sale and then again when dividends are transferred to the shareholders.
With a stock purchase, the buyer acquired the selling shareholders’ stock or membership interests (for an LLC) directly through a sale. As such, the seller just steps in place of the seller, and the business and legal entity will carry on. Unlike an asset purchase, stock sales do not require numerous separate conveyances of each asset because the title lies within the corporate entity.
Because the buyer is taking the seller’s place, there is no step-up in basis. The seller will pay capital gains on the difference between the sale price and the seller’s basis in the assets.
The stock purchase agreement can mitigate these liabilities through representations, warranties, and indemnifications.
For example, a company may have government or corporate contracts, copyrights, or patents that could be challenging to assign. A stock sale could be a better solution because the company, not the owner, will retain the ownership. Also, when a company is dependent on a few prominent customers or vendors, the stock sale can reduce the risk of losing these contractual agreements.
Sellers often favor stock sales because all the proceeds are taxed at a lower capital gains rate, and in C-corporations, the corporate level taxes are bypassed.
Defined benefit plan or cash balance plan
So now, let’s get back to what happens with your defined benefit plan. As stated above, the company carries on with a stock purchase as it usually would. So there was actually no change to the retirement structure. It would still cover the employees and potentially any compensation for a new owner.
But the existing owner would be terminating their employment with the company and, as such, would roll any vested balance over into their IRA. The seller should make sure that they give the buyer the plan documents and make sure that they still want this plan to carry forward.
The buyer does not want to continue with a defined benefit plan in many situations. This is often the case if they are a smaller, more non-sophisticated hire who does not understand the complexities of these plans.
Alternatively, it could also be a large acquirer who already has a different structure in place. This may these employees may be covered under the control group rules. But in either event, make sure discussion of the plan is brought up in the acquisition paperwork.
But under an asset purchase transaction, the plan will still stay with the old company. The old company now would have no assets or possibly limited assets that weren’t part of the sale. The owner might continue to use the corporation for operating another business.
It is also common for a business acquirer to undertake a consulting agreement with a seller to pay them a certain amount as an independent contractor consultant. This money can then go to the old company still owned by the seller. As such, the seller can continue to use the defined benefit plan as a tax deferral on this additional consulting income.
However, even though the seller might choose to keep the plan for additional operations, they still need to terminate and pay out the employees covered under the defined benefit plan. In most situations, these employees will become immediately vested, and balances can be rolled over into individual IRAs.
As you can see, how a business transaction is structured is critical to determining what happens with the defined benefit plan. Make sure you consider these issues upfront.
Generally, more minor business sales are usually structured as asset purchases. The buyer gets the tax advantages and does not assume any liabilities. However, many are structured as stock sales for larger companies with a well-known brand and many existing contracts.
Each business transaction is unique, and buyers and sellers should consult with their CPA and attorney to ensure the transaction is structured correctly.