What’s your getaway plan? Do you know how you will step back from the hustle and bustle of business and fund your happy retirement? Do you have a pension fund? Will you sell your company? The question of a tax-effective exit-cum-retirement is a recurring one, and because the legislation and language around pensions are so impenetrable, they often leave people feeling bewildered.
I caught up with Michael Ryan of Gara Ryan to get his thoughts on what business owner-directors should be thinking about in relation to retirement.
We’ve discussed before how the value of service businesses has been falling due to commercial realities and buyer behaviour. Where in the past you would have been able to sell a service business for many times its annual revenue, these days its value is possibly no more than the balance sheet, because its true worth lies in the individual relationships that keep it going. It’s different for non-relationship-based companies (a supermarket, for example), but here in Ireland we have lots of service businesses where the owner-operator would have previously considered the business itself to be his or her pension plan. In a world where this is no longer the case, alternative provision is needed.
Pension options for owner-directors
Executive Pension Plans (EPPs)
Pensions are a very tax-efficient way to take money out of a company. Most people running a company that they own should be paying into a pension scheme. Traditionally, a lot of business owners would have set up an Executive Pension Plan (EPP), which is technically a company scheme but is just for that individual. They are attractive because the company can pay fairly substantial tax-deductible amounts into this scheme, and they are not considered a benefit in kind (BIK).
The level of contributions a company can make is determined by the scheme actuary and based on the individual’s salary, their period of service with the company, and their age. The pension provider will give you an amount based on these factors. If you are older and have a long period of service but no other supplementary pension provision, the amount you will be able to pay into such a scheme will be substantial. However, if a large lump sum is paid to an executive pension, Revenue may seek to spread the tax deduction over three to five years.
Last year, compliance for EPP trustees became more onerous and the knock-on cost implications meant they became problematic for thousands of small pensions schemes. In fact, there was a period of time during which pension providers weren’t selling them at all. To ease the cost burden, small schemes were encouraged by the regulator to enter a ‘master trust’ structure instead, and these have started to be made available by companies such as Zurich.
Personal Retirement Savings Accounts (PRSAs)
This year has seen big changes to private pension schemes, or Personal Retirement Savings Accounts (PRSAs), which makes them more interesting to business owners. The Finance Act 2022 was enacted on 15 December 2022. The headline change is that if an employer pays into a PRSA, it is no longer considered a benefit in kind (BIK), with effect from January 2023.
Currently, it appears that there is no upper limit on employer contributions to a PRSA, as there would be in occupational pension schemes such as the EPP (for now, there may be regulation on the way). The only limits seem to be related to the lifetime pension fund limit, known as the standard fund threshold or SFT, which is currently €2 million. The salary level, service to date, and amount of pension benefits already accrued are not factored into the ability of that employer to contribute to the PRSA.
Employers can only contribute to the PRSA of registered employees receiving a salary under Schedule E with PAYE taxation applied at source. Additionally, the employer’s capacity to fund a significant contribution will be based on profits and corresponding taxes paid. The details are still coming through, but it looks likely that (in contrast to EPPs) tax relief on contributions will be allowed in the year they are paid, without an upper limit.
Which pension option to choose?
PRSAs offer good value, as they were set up with restriction on what providers can charge as commissions. Additionally, there’s no requirement for trustees or master trusts and the subsequent paperwork and cost they would entail. Some directors will find the new changes to PRSAs beneficial, in particular those on lower salaries who couldn’t save as much as they wanted to under an occupational pension scheme or those with larger salaries and big profits who want to access the tax relief right away. Another benefit of PRSAs is that, in the event of the individual’s death, the full value is paid to their estate. With EPPs, there are certain limits.
Don’t put all your retirement eggs in the one basket
As you can see, the government is doing a lot to make pension planning more attractive because tax breaks alone weren’t cutting it. We looked recently at the upcoming launch of auto-enrolment pensions, widely hailed as a once-in-a-generation shift in the pensions landscape. But who knows what other changes are coming down the tracks. If you are a business owner-manager, you have another way to plan for retirement.
As Michael points out, pushing everything into a pension may not be your best option as a business owner. Both an EPP and PRSA will let you access 25% of the fund in a tax-efficient manner upon retirement. But the remainder will be taxed as income. Let’s say you have a pension pot of €2 million. 25% of this is €500,000. The first €200,000 of this is tax-free and the balance will be taxed at 20%. So, your tax bill on the initial one-quarter lump sum will be €60,000. As you draw down the remaining €1.5 million, you’ll pay income tax on it – 20% or 40% depending on how much you need each year.
Retirement Relief
But bear in mind that once you are over 55, you’ll qualify for Retirement Relief. If you have plans to sell your business, this will give you Capital Gains Tax relief of up to €750,000. So, there may be a benefit in building up cash in the business (up to €750,000) with a view to a share buyback after you have turned 55.
In such a scenario, rather than trying to sell the company, you are making way for new management. You may have a couple of employees who are interested in taking it forward. The business has 100 shares, and you give them each a share – now they own a small piece of the business, but you haven’t created any significant tax consequences for them. At some point after turning 55, you retire as a director it is therefore for in the interests of the company that you exit the business (a buyback must always benefit the company’s trade).
The business itself buys back your shares from you. The two employees you brought as minor shareholders now own the business between them. They have gained ownership of a going concern without having to come up with the money themselves. If the business doesn’t have the cash for the buyback or is a bit short, the new shareholders could look at a bank loan or other ways to finance it. One thing to note is that you won’t usually retain any shareholding in the business as you should cut ties with the business – i.e., not remain as a director or employee – although there is a short grace period to allow this transition to go ahead smoothly.
In Michael’s opinion, it would be a mistake not to avail of Retirement Relief where possible and I agree. Obviously, it will depend on your specific circumstances, but it makes a lot of sense to factor future taxation into your calculations and have a mix of tax-free cash from the business plus your pension pot.
