*by Dr. Johannes Fiala, lawyer (Munich), mediator (Univ.), MBA Financial Services (Univ.Wales), MM (Univ.), certified financial and investment advisor (A.F.A.), lecturer for civil and insurance law (BA Heidenheim, Univ. of Cooperative Education), banker (www.fiala.de) and Andreas M. Bosl, management consultant (Pöcking/Starnberg) Managing Director of Mittelstands- Strategie-Beratung GmbH and owner of MBD Mittelstands-Beratungs-Dienst e.K. (www.mbdbav. de)
The pension commitment: tax savings model or tax trap?
The advantages of a pension commitment are sufficiently known to every tax consultant and GmbH controlling shareholder-managing director. Tax advisors have also recommended this pension plan to their clients in order to reduce taxes and increase liquidity in the company. However, experts estimate that over 90% of all GmbH managing directors have been promised a pension for retirement that cannot be financed by the GmbH. Most of the reinsurance concepts of the pension commitments have gotten out of hand with predominantly German endowment policies. Since the stock market crash in the years 2000 to 2003, the profit sharing and promised returns of German insurers have practically vanished into thin air. Of the promised returns of around 7.0 % p.a. originally determined using non-binding sample calculations, only 4.0 % or less p.a. remained for many insurers. This means that for many commitments the necessary funds for later pension payments are lacking: With a term of 20 to 30 years, coverage gaps of 40 to 50 percent quickly arise by the time the pension starts at the age of 65. This is a fatal situation, as the tax authorities are now paying more attention to the financial viability of pension commitments and, if they cannot be financed, are quickly accepting hidden profit distributions. The unfunded pension commitment is discussed at the latest in the event of anticipated succession, the sale of a company or a succession arrangement. What began as a tax saving model can later lead to unavoidable tax burdens and an impending old-age poverty of the managing director. Numerous tax advisors are aware that the majority of their clients have become economically over-indebted as a result of pension commitments for these reasons. Insolvency can thus be pre-programmed, as it were. Risk of the company purchaser and in the case of anticipated succession ! A further disadvantage of the pension commitment is above all the fact that when the GmbH is sold, nobody really wants to buy a GmbH with an existing pension commitment. A lifelong obligation to pay an annual old-age pension of 36,000 € to 60,000 € is something that no successor would want to tie himself to his leg. The liquidity of the company is often endangered in the short term with such a high monthly burden, especially if the pension commitment was calculated – as usual – only at the low tax values. The risk of the company buyer is expressed in the fact that often less than half of the assets are available that would be necessary to pay a lifelong pension. Financial service providers are happy to recommend the formation of additional reserves for classic restructuring – sometimes also referred to as “outsourcing the pension commitment”: Unfortunately, however, this approach hardly changes the liability of the Mittelstands-GmbH, nor does it change the fact that the financial means for further reserve formation are too rarely available. Capital compensation as a lifeline? The tax advisor then usually advises a lump-sum settlement of the pension commitment, since the continuation of the commitment with payment of monthly old-age pensions by the GmbH is not financially viable in the long term and often ends when the managing director reaches the age of 75 or 80. In the case of a lump-sum settlement at the age of 65, however, it is important that the corresponding agreement is formulated and available in the exact wording of the pension commitment. However, many pension commitments are not up to date with the wording of the text modules today because important BMF letters have not yet been implemented. A settlement of the commitment will then often not be possible or will be treated by the tax office as a hidden contribution: The manager will then have to pay tax on the part of the pension he has waived, i.e. tax on non-existent income. The expert opinion of an actuary on the pension commitment also helps to considerably reduce liability in the event of a tax audit by the tax office. For the entrepreneur, the realization that long-running contracts, especially when it comes to one’s own provision in old age, require regular review and adjustment is also bitter at first glance. In the case of the restructuring of pension commitments, it is also advisable to consult advisors who initially do not want to sell “financial products”, but who are rather in a position to show the entrepreneur the most varied ways. Tax-neutral settlement of pension commitments As things stand today, a pension commitment can be settled using the so-called one-fifth rule or the personal tax rate. However, the current regulation means that although the pension commitment can be removed from the GmbH’s balance sheet in the case of congruent reinsurance, the severance payment is considered a taxable inflow for the managing director in the private sector. However, this presupposes that there are sufficient assets in the GmbH to pay compensation – otherwise there is a risk of partial taxation of unpaid partial pensions due to the managing director’s partial waiver of his claims. In the case of a complete severance payment of, for example, € 500,000, taxes of € 100,000 to € 200,000 are quickly due and payable immediately in the year of the severance payment. Then there may only be about 350,000 € left for the pension scheme. With a retirement of these 350.000 € the managing director receives then with the German pension insurance just a lifelong old age pension of approx. 17.000 €, thus about only half of the imagined old age pension. This means that the beautiful dream of a €35,000 old-age pension is over. Solution approach of the compensation over trust donation However there is just as elegant, as simple solution of all these problems of a GmbH and their partners managing director, at the latest with pension beginning to the 65th year of life. The management consultant Andreas Bosl says: The establishment of an own non-profit trust foundation, which is particularly privileged and promoted by the Federal Government since the year 2000 from a tax point of view, is almost an ideal concept for many medium-sized companies to solve various problems in a bundled form. Decisive advantages arise in the case of inheritance tax, gift tax, final withholding tax, redemption of bank and mortgage loans, royalties, sale of GmbH shares, succession arrangements, the sale of companies, but also in the case of severance pay for executives and, above all, in the case of tax-neutral spin-off and severance pay for pension commitments in combination with a charitable trust foundation. Tax advantages through foundation assets In the case of privately assessable assets contributed to one’s own trust foundation in the amount of, for example, € 600,000 (rented real estate East and West, securities, fixed-term deposits, cash, works of art, etc.) and a private tax rate of 40%, this would result in a tax refund of approx. € 240,000 in liquidity inflow in the next 5 to 10 years. Depending on the taxable income, the tax refund may be higher or lower. If one now applies this tax refund or the reduction of tax prepayments for 10 years with e.g. 6%, an additional private wealth of about 350,000 € results in 10 years. This means that a tax burden of €100,000 to €200,000 on the settlement of a pension commitment can then be elegantly absorbed without headaches, leaving around €150,000 for an additional private pension of one’s own, net of course. This model can be expanded, as the federal government decided in the reform passed this year that each spouse is entitled to a foundation allowance of up to EUR 1.0 million (spouses a total of EUR 2.0 million). The tax deductibility as private special expenses, in the context of the establishment of an own trust foundation, applies according to the bill, retroactively to 01.01.2007. In the trust foundation, moreover, there is no longer any gift or inheritance tax on the assets contributed, e.g. real estate, securities, etc. In addition, all private assets transferred to the foundation are protected against insolvency after 4 years. With around 36,000 insolvencies a year, the entrepreneur feels he is on the safe side with his trust foundation. However, this still requires some minor adjustments when it comes to the overall asset protection of the entrepreneur. The difficulty, as always, is that only select specialists can provide complete advice and set up trust foundations. The variant of the tax-neutral transfer and spin-off of pension commitments from the GmbH and the parallel required establishment of an independent charitable trust foundation, also requires the complete expertise of a GmbH pension commitment and a trust foundation. Experts who are proficient in both areas of expertise and, moreover, who overlap with each other, are rare and can only be obtained in return for fee-based advice. For the tax advisor and his clients, however, this package solution means almost a “perpetuum mobile”. Because it secures the mandates for the tax adviser in the long run and the GmbH managing directors have put their “problem pension promise and inheritance tax” for ever ad acta.
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About the author
Dr. Johannes Fiala has been working for more than 25 years as a lawyer and attorney with his own law firm in Munich. He is intensively involved in real estate, financial law, tax and insurance law. The numerous stages of his professional career enable him to provide his clients with comprehensive advice and to act as a lawyer in the event of disputes.
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