Defined benefit plans are great retirement options. But how do they work if you sell a portion of your business? More specifically, we get questions like this all the time:
I am selling 30% of my business to a partner. How will this impact my defined benefit plan?
The answer to this question is: it depends. There are a lot of dynamics at play with this question. This post will cover the topic and examine some of the issues you must consider. Let’s jump in.
Some Background
First, you must realize that retirement plans are company-sponsored plans. What this means is that your company is the one that is setting them up for all eligible employees. You may be the only eligible employee, but once other employees (or partners) come into the mix, they may be required to be included in the plan.
Remember that a defined benefit plan is not “your” plan. It is the company’s plan. So, if there are eligible employees, you will have to pass testing to determine whether or not those employees are included in the plan.
In addition, when you think about the above question, some follow-up questions should be answered:
- Will your partner work in the business or are they just passive investors?
- Does the new partner want to participate in the plan?
- If they work in the business, is there a desired compensation they will receive?
- Is there a retirement benefit they’re looking to receive?
- How many hours a year will they work in the business?
In addition to these questions, you must consider the intentions of the two business owners. The new partner should at least understand that a plan is in place and discussions should be held to determine whether the plan should be continued or possibly terminated.
Let’s assume the new partner bought 30% of the business. They might not be happy knowing that a portion of the business profits is going to a retirement plan that they’re not able to participate in. This can result in partnership disputes.
Is your new partner passive or active in the business?
The most important issue that you’ll have to grasp when it comes to selling a portion of your current business is determining the role of the new business partner. Are they a silent investor who just put money into the business or are they actively working in the business?
If your business is structured as a C-Corp or S-Corp and the investor is working in the business, then they should receive W-2 compensation. Because they’ve received this W-2, they are an employee and as long as they meet the eligibility requirements (discussed later), they would be able to participate in the plan.
But what if the new person came into a partnership structure and they received a K-1 at the end of the year? Under this scenario, you have to look at the K-1. There will likely be an amount in box 1 showing the ordinary income that is passing to the investor.
But if they don’t work in the business this ordinary income will NOT be subject to Social Security and Medicare. As a result, they are not technically an employee working in the business so they would not be eligible.
You have to look at box 14a on the K-1. This is the box that signifies the income that subject to employment taxes. if there’s an amount in this box, then they are working in the business. If not, then they are simply a passive investor.
Ownership vs employees
It’s important to note that because these are company-sponsored plans for eligible employees, we only care about the employees. We don’t care about ownership.
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Ownership can come into play with control group and affiliated service group rules. But that is above the scope of this discussion. The point is that merely being an owner does not entitle you to be eligible for company retirement plans.
Ownership does come into play when considering control groups and affiliated service groups. But in general, ownership is not a consideration most of the time.
For example, you can go out today and buy stock in Apple, Microsoft, or any other stock for that matter. But just because you own the stock does not mean that you are entitled to participate in the company’s fringe benefit plans or retirement plans. You are not an employee, so you’re not eligible. Said differently, just because you own stock in a company does not mean that you work for the company.
When you think of it in this scenario, it’s pretty straightforward. But again, people fail to realize that these are really employee benefits.
What are the eligibility requirements?
These plans have many rules and requirements. But let’s examine the top three typical defined benefit plan eligibility requirements:
- Age-related restrictions. Defined benefit plans can have age restrictions. Plans may exclude anyone under the age of 21 from eligibility.
- Year one exclusion. The plan may also require a specific amount of time before participation. For example, many plans use a one-year service requirement.
- Minimum hours. You can restrict participation based on the hours worked during the plan year. The plan may limit eligibility to only employees who work over 1,000 hours.
The entrance date is when a plan allows employees to enroll once the service conditions and age requirements are met. Common entry dates are quarterly, semi-annual, or annual.
Final thoughts
Selling a portion of a business while maintaining a defined benefit plan can significantly impact both funding requirements and long-term plan obligations. Since defined benefit plans are based on projected retirement payouts rather than fixed contributions, any change in ownership or business income may shift actuarial assumptions.
Is a Cash Balance or Defined Benefit Plan Right For You?
If the plan remains with the selling owner, they must ensure the business continues to generate enough income to fund the promised benefits, potentially straining cash flow. Alternatively, if the plan is split or transferred, clear documentation and valuation are essential to avoid compliance issues or IRS scrutiny.
Ultimately, defined benefit plans offer significant tax and retirement advantages, but owners must navigate complex implications during a sale. Proactive planning ensures the plan remains compliant, adequately funded, and aligned with the business’s new structure. Whether retaining, amending, or terminating the plan, addressing its future during the sale process is essential for avoiding financial surprises and ensuring a smooth transition.
