Money Market or Stock Market?
Mason contractors and suppliers have continued to experience solid demand in the current economic down cycle. As noted previously, the press continues to pronounce many corporate officers untrustworthy, meanwhile trillions of investment dollars are now parked on the sidelines in the lowest money market rate we have seen for 50 years.
Opportunity knocks! Family-owned construction companies and their suppliers that are currently generating some good, positive cash flow can take advantage of this timing to shore up the business and the balance sheet.
I don't usually talk about insurance as an investment vehicle, but right now it makes a lot of sense — if you do it right.
First, if you have a family corporation with a half dozen or less key people, or a larger enterprise with several dozen key employees, you might want to set up a non-qualified, deferred compensation plan.
The idea is that the profit in the company — where it is not a sub-S election — is taxed at a rate of about 15 percent or so, up to $50,000. Many contracting and supplier companies use depreciation expense to generate additional excess cash. Therefore, as much as $75,000 to $100,000 in cash may be available this year, sitting in the money market doing a 0.8 percent per annum pre-tax return. That's not putting the money to work.
Consider using the company cash by setting up a group variable universal life policy for your key people. The people enter into an agreement with the company called a non-qualified, deferred compensation agreement, in which they agree that the company will own the cash in the policy until they either leave or retire. The policy contributions to the plan are not tax deductible to the corporation now, but build up on the balance sheet as a current asset ("other assets").
The agreement can be set up to pay a portion of the accrued policy value to the participating employees on a five to 10 year basis or substantially upon retirement. This transfer of the right to some of the deferred compensation would move the funds to the employee's account at that time. That means there is no tax to the employee until the money is distributed. However, when the funds are paid out, the company deducts the payment as a business expense in the year paid. This can be paid out on an annuity basis if the employee doesn't want a large, taxable cash payment on retirement.
Now these policies — the variable universal life kind — have a couple of other nifty wrinkles. First, if you are having a bad year, somewhere down the road, cash flow wise, the cash accruing in this "deferred compensation" account is company money. In your agreement to act as trustee of this policy, you may be able to borrow from it in difficult times at a low interest rate. Another possibility is you may be able to set a minimum level of company profits required to make additional contributions or allow the employees to request payments in lieu of raises.
Of course, the intention is to transfer funds to employees, so they will want this handled carefully, as technically it is additional retirement money. Second, the liability to pay out to employees who are "qualified" under the plan, having enough years of service, or reaching the age of retirement, is a long-term, deferred liability. Thus, this strategy can build up over a number of years. $100,000 per year plus, for instance, six percent interest in 10 years, will create a current asset of nearly $2,000,000. For construction companies this is a particularly attractive situation, as current assets count in underwriting job bonding.
Finally, in the closely held family company, 401(k) rules, due to the low contributions of middle management and rank and file members of company plans, tend to come up short for key managers. The top-heavy rules kick in and the owners end up making contributions that are way short of their needs to replace salary and benefits come retirement. This is a special problem when family business transition time comes (if you don't set up a deferred compensation plan) and the creating generation is trying to make an effective transfer of the business ownership to second and third generation members.
Short contributions into the 401(k) plan will mean older family members have to rely on continuing to take some money out of the business cash flow to effect retirement. A deferred compensation plan set up with 10 to 20 years left until retirement can eliminate this as an issue in selling the company to the children.
Setting up a non-qualified, deferred compensation plan has many strong rational attractions. These plans are set up by highly qualified life and estate planning type financial planners for clients. We use a regional wholesale insurance broker to get the best rates on these plans, as there are large variances in investment options and insurance rates between companies. By using a regional broker we can get a range of choices to consider, so that whenever the market turns up, we can be there to move funds into growth and value mutual fund choices available as alternatives to the fixed account. As usual, this strategy is going to need a visit from your accountant and/or attorney to make the proper choices once you have a proposal in hand.
In our opinion, doing nothing right now is going to penalize your returns, as we don't see much increase in money market rates in the near future. As noted previously, history suggests we are at or near a market bottom and this strategy will help you participate in the next big rally with no significant short-term risk.
Feel free to send an e-mail to firstname.lastname@example.org with your questions.
About the Author
Wayne F. Currie is Chairman and CEO of Incentive Capital Management, Inc. He has been a financial planner and investment advisor since 1970.