Does Your Professional Services Firm Make These 3 Financial Planning Miscalculations?

By Charles J. Lewandowski CFP®, MBA

Closely held professional services firms may share several common characteristics:

·        One or two founding employees run the business and generate most of the revenue.

·        The founders intend on selling the company to fund their retirement.

·        If there is a staff, it consists of well compensated technical support personnel.

·        There may be a small clerical support staff.

Many owner-employees are required to run the company while generating new business. So, time becomes an asset. Conservation of time, however, can be very expensive. Innocent shortcuts can lead to financial planning errors. Here are three mistakes that owners of professional services firms may experience.

Mistake #1- Using a payroll provider’s 401k plan to fund retirement –

 Larry Litigator is the lead attorney and majority shareholder in a successful law firm. He employs 5 junior attorneys and two clerical employees. He uses ABC Payroll for his company payroll needs. The ABC representative recommended that Tommy use the payroll provider’s standard 401k offering because “all 401k plans are the same” and it was “free” with ABC’s payroll services. Tommy agreed. The following year, Tommy was notified by ABC that he must reduce his salary deferral as well as his employee attorneys because the 401k plan “failed testing”. Tommy’s CPA also said that he owed significantly more Federal income taxes because of his increased income. Where did Tommy go wrong?

Many 401k plans offered by payroll providers can be considered boilerplate, off the shelf retirement savings vehicles. For many businesses, these plans may be appropriate. However, in firms like Larry’s, the payroll structure requires a retirement plan that incorporates features that allows for maximum contributions by both the highly compensated owners and employees as well as the clerical staff. Safe harbor plans, new comparability plans, and combination 401(k) /cash balance plans should be evaluated by a team of tax advisors, financial planners, and plan design experts. A creative plan design can result in many thousands of dollars of extra tax and retirement savings which may dwarf the expected savings of a “free” retirement plan.

Mistake #2 – Using a SEP IRA instead of a Solo 401(k) for retirement funds –

Jenny Techster, Licensed Architect, started a one-person consulting firm that designs high-end office complexes. Jenny founded the practice when she was 49 years old. Her CPA recommended that she open a SEP IRA and contribute the maximum amount allowed by the IRS each year to increase her retirement savings. She religiously contributed to the SEP for the next several years. Before she retired, she hired a CERTFIED FINANCIAL PLANNER ™ professional (CFP®) to evaluate her retirement preparations. Her CFP® said that she was missing a retirement savings opportunity that was worth $6500 in 2020 and that additional savings were missed since the year she turned 50. Jenny wanted a “word” with her CPA.

A SEP IRA is a great retirement savings account for sole proprietors. But it does not have a “catch-up” provision which allows the wage earner to increase their annual salary deferral. A Solo 401(k) has this feature. Once the independent business owner turns 50 years of age, both the SEP IRA and Solo 401(k) should be evaluated to determine which will provide the maximum savings opportunity.

Mistake # 3 – Failing to Formalize a Succession Plan –

Kevin Greenbull and his partner, Christine Golden, founded a civil engineering firm which specialized in structural design for bridges. Christine owned 51% of the company. The firm became quite successful as the economy in the Sunshine State continued to rise with the in-flux of new residents. Kevin and Christine both assumed that at some point, one would retire and the other would take over that person’s ownership stake, but those thoughts were never incorporated in a legal agreement. Unfortunately, while working on a job site, Christine was hit by a construction crane and passed away. Several weeks later, Kevin was notified by Christine’s husband that he was selling Christine’s shares to the firm’s biggest competitor. Kevin’s vison was now whatever his competitor wanted it to be.

Unpredictable events such as death, disability, or financial stress can lead to a change in firm ownership that does not fit with the owners’ original intent. In this case, Christine’s husband had many options regarding the disposition of his shares and Kevin had few. It is critical that owners of closely held firms formalize their succession planning intentions with the help of an attorney.

Bonus Nugget – Mistake # 4 – Forgetting Tax Credits for Small Business Retirement Plans – The SECURE Act of 2019 enhanced tax credits for the implementation or enhancement of certain retirement plans. Your tax advisor can help determine if they make sense for your firm.

With proper planning and success, professional services firms can generate significant wealth for their owners and employees. If your firm is on this path, create a team of trusted advisors including an attorney, CPA, and CERTIFIED FINANCIAL PLANNER™ professional to help preserve and enhance what you’ve created.

08/2020

Advisory services offered through Capital Analysts or Lincoln Investment, Registered Investment Advisers. Securities offered through Lincoln Investment, Broker Dealer, Member FINRA/SIPC. www.lincolninvestment.com 

West Coast Financial Group, Inc. and the above firms are independent and non-affiliated.

Tax advice is not offered through, nor supervised by Lincoln Investment or Capital Analysts.

Contributions to a Roth IRA are not tax-deductible and there is no mandatory distribution age. All earnings and principal are tax-free if rules and regulations are followed. Eligibility for a Roth account depends on income. Principal contributions can be withdrawn at any time without penalty (subject to some minimal conditions).