Owners of construction companies are great at completing construction projects on time and on budget, but many struggle or fail to build a succession plan for themselves or their business. Like most construction projects, a succession plan is based on your objectives; it should accommodate your goals for yourself and your business, including considerations of wealth, family, and legacy. It’s a complex process involving a multitude of financial as well as personal considerations and the contributions of a variety of financial and other professionals. In my work with contractors spearheading their succession planning, I serve not only as their accountant and trusted advisor, but as point person, coordinating multiple internal experts from our multi-disciplinary firm—financial planners and investment managers from our wealth advisory, our tax and audit professionals, and members of our Valuation and Transaction Advisory teams—as well as other professionals they will need to properly execute a transition, such as attorneys practiced in the legal aspects of selling a business and other business succession strategies.

Because planning a contractor’s eventual exit from their business is a complex and multi-faceted process, we encourage you to start early. Even if you don’t plan to sell your business or transfer it to employees or a next generation for many years, it’s advisable to gain an understanding of the value of your business so that you can start doing things now to ensure that when it is time to sell, you’ll get the best possible return on what is surely the biggest investment of your life. Besides, who knows when the opportunity will come? A suitor could appear at your door any day. But no matter when it comes, you want to be ready—and as my HBK colleague and business valuation expert Robert Zahner says, “If you stay ready, you don’t need to get ready.”

So how do you start? Let’s examine the details by organizing our approach around the three questions you as a contractor must consider as you develop your exit plan and plan your transition:

How much is my business worth?

It’s typically the first question someone asks themselves when they consider selling their business. Of course, you need to know what your business is worth prior to making a decision to transition or sell. Knowing the likely price allows you to improve or enhance the value of the business if it is not currently worth what you think it should be. To increase your company’s value, you first need to understand what drives value in your business so you can focus your time and resources on maximizing that. Consider your strengths, the type of jobs you do best, and the financial and operational metrics a prospective buyer is likely to focus on. You also need to identify your areas of weakness, so you can implement a plan to convert weaknesses to strengths prior to putting your business up for sale.

“The first step in a construction business valuation is ensuring you have up-to-date accounting information that addresses the most important KPIs (key performance indicators) for contractors,” Zahner pointed out. “Percent of completion accounting is more involved than completed contract accounting, but it also provides deeper level, more sophisticated accounting information, more of what buyers want to see doing their due diligence.

“It’s not just top-line profitability that a buyer will look at. You have to track a variety of KPIs, such as percentage of jobs completed on time, percentage completed on budget, and data on labor productivity.” Zahner provided the following list of construction firm KPIs:

• Labor productivity – work hours per unit installed
• Schedule performance – percentage of projects completed on time
• Cost performance – percentage of projects completed within budget
• Equipment utilization
• Safety incident rates
• Client satisfaction scores
• Change orders
• Rework rate
• Employee turnover, training completion rate
• Bid win rate
• Financial ratios: liquidity, leverage, and profitability
• Work-in-progress schedule accuracy
• Backlog-to-revenue ratio
• Accounts received greater than accounts payable
• Return on investment

“When contractors begin their succession planning early, they have time to address weaknesses, to improve areas of performance as they approach the time when they are ready to sell,” HBK Valuation’s Zachary Politsky said. “For example, negotiated contracts tend to have higher margins than competitively bid contracts, and higher margins are a high-priority KPI for potential suitors.

“Markets matter as well. Areas with strong, long-term upward economic trends are obviously more attractive to buyers, but particularly attractive to builders and subcontractors. So timing is an issue; if your local economy is slowing, it’s not going to be the best time to put your business up for sale.” Other areas contractors can work on to improve the value of their companies, according to Politsky:

• Goodwill value (for subcontractors): Particularly in heavy construction, subcontracting can be extremely capital intensive, so it is important that subcontractors build goodwill value through a reputation for quality work and service, timeliness, and by staying on budget. 
  
  
• Recurring customers: Repeat business can mitigate ebbs and flows typical in the industry. 
  
  
• Skilled labor: Shortages are risky. Buyers know that contractors who can attract and retain skilled workers tend to flourish.
  
  
• Poor safety: A history of poor safety can have a negative impact on insurance availability and rates, as well as on recruiting and maintaining a quality workforce.
  
  
• Bonding relationships: Strong bonding relationships reduce risk and thereby increase value.
  
  
• Employee turnover and percentage of employees who complete training: These are also KPIs that are closely examined by a savvy buyer.

“Use customer satisfaction surveys to identify areas for improvement, then pick five to ten KPIs that resonate with what drives you competitively and what you can improve on,” Zahner advises. “Identifying and tracking your progress over time is important, and the sooner you start the more you can measure and improve.”

Who am I selling to and how?

Whether you are selling to a third party, a next generation family member, or transferring the business to your employees, understanding the buyer and structure of the sale are just as important as the sales price. You need to know how a particular buyer will pay you: a lump sum payment, payments over time, or perhaps with part of the purchase price tied to the future performance of the business.

My colleague Keith Veres is the National Director of HBK Transaction Advisory Services. He and his team work closely with clients looking to sell or buy a business, overseeing and coordinating the process from start to finish.

“We make sure a seller understands all their options,” Veres explained. “Often they come in wanting to sell internally, but when they examine their options, they might decide to sell externally.”

Selling to an employee or employees generally means, “you’ll be the banker,” Veres said. “It’s an installment sale, and your employees will likely pay you from the business’s ongoing profits over a period of years. In essence, you haven’t sold the business, and you might be back inside running the business again if they aren’t able to make the payments. You’re also still on the hook for liability in an industry where there is more potential for lawsuits than most other businesses.”

If you’re going to use an employee stock option plan (ESOP) to transfer ownership to a management team or all your employees, “you might be able to get 60 to 70 percent of the value upfront,” Veres noted. “We work as a professional go-between for the management team with bankers or investors to get as much financial support as possible for the employees and the best possible deal for the seller.

“Often sales to an outside party, including a private equity firm, will net the seller a large percentage of the sales price upfront, 70, 80, even 90 percent. But you need to stay in the business during a period of transition to help the new owner. If the business grows, the value of your remaining ownership grows with it. You might be able to get the full amount of the sale price from someone in your industry who doesn’t need your help in transition, and you can truly move on.

“Or you could sell a minority interest and continue to run your business with a partner who can help you grow the business beyond what you might have been able to do yourself.”

Veres employs a four-step process in a first meeting with a client looking to sell their business:

1. “Everything starts with a realistic market-based valuation. A contractor might have an idea of what the business is worth, but every business is unique: different customer bases, different specializations, different community involvement. A realistic valuation that thoroughly understands your business is the critical first step. You don’t want to be making decisions in a vacuum.
   
   “The valuation identifies what drives the value and what subtracts from the value of your business. A buyer wants to find reasons to put downward pressure on your selling price based on what they discover. We identify those issues, work first on the low-hanging fruit, then prioritize other items that will take longer to resolve or improve. It’s a comprehensive process to get to the true value, including accounting for what you’re taking out of the business in addition to W-2 income, like cars, insurance, cell phones; we can normalize these benefits in a way that explains it to the buyer. Then we can collaborate with the accountant on the team to estimate what you’re actually going to take home from the sale after taxes and other expenses.
   
   
2. “Does the seller have a financial planner? If not, we can introduce them to a professional who can work with them to develop their retirement financial plan. A retirement plan is distinctly different from a pre-retirement financial plan because you’re no longer saving for retirement, you’re spending those savings. How will you monetize your business, which typically represents the majority of a business owner’s wealth? Will the proceeds from the sale be sufficient, or is there a gap? Will you need to reduce your expenses in retirement or do you need to fill that gap before you sell?
   
   
3. “We ask the seller to allow us to be candid, that is to examine their business from the buyer’s perspective.  We don’t want the seller to be surprised by a prospective buyer’s questions.
   
   
4. “There are two transitions. A seller must consider their personal transition, what they want to do next. As to transitioning the business, beyond the valuation, we consider everything required to run the business, the operations, the relationships. For example, we have seen landlords kill deals because they weren’t confident in the buyers. A thorough understanding of what will be required of the new owners will help the seller decide how to sell the business as well as if the time is right. ”

Contractors need to understand the structure of the sale or transition and how that aligns with how they operate their business. An asset sale and a stock sale can have widely different impacts on both buyer and seller. Any sale or transition will have its own set of variables and considerations, but understanding who you are selling or transitioning to and how will help you decide how to operate your business leading up to the sale or transition.

Will the sale produce enough wealth to fund my retirement plans?

Most contractors spend their lives building their businesses’ balance sheets and keeping them strong, but don’t have a personal balance sheet or a “what’s next” plan. Like succession planning for your business, a personal succession plan, or financial plan, addresses what you want your life to look like after business, in retirement. Maybe you want to pay for your grandkids’ college educations or travel extensively. Whatever your retirement goals might be, it’s important to establish them prior to selling your business in order to determine if your selling price will support them. Creating and maintaining a personal financial plan will help you determine whether the sale of your business will produce sufficient capital to support your goals and lifestyle as you transition to retirement or another venture.

I asked Brittany Taylor, a senior financial advisor with HBKS Wealth Advisors, to share her approach to developing financial plans for retirees.

“What you have to consider to determine if you have enough to retire depends on who you are and how you want to live in retirement,” she began. “Some of my retiree clients live on $100,000 a year; others need more than $500,000.

“We start with your expenses, but also what additional you want to do with the money, such as travelling, buying new cars every couple of years, paying for your kids’ weddings or college educations, or contributing to charitable organizations. We look beyond current expenses, like future healthcare costs, such as in-home nursing if someone were to get sick. You have to account for unanticipated costs like replacing household appliances, maintenance and repairs, or moving to a new house. All those expenses will be impacted by inflation. And there’s your legacy: your retirement financial plan should accommodate your estate plan.

“If you’re selling your business in your mid 60s, current research says you have a 50 percent chance of living to age 93 and a 25 percent chance of living to age 97. So you’ll need money for 35 years. We look at the client’s existing resources: Social Security, a 401k or defined-benefit pension plan, their savings and investments. The rest will come from the sale of the business, and for most business owners, that’s where most of their money is tied up. If we can start working with a business owner early on, we can help them build wealth outside their business, like through a company benefit plan or another tax-advantaged way to build savings.”

Taylor pointed out that a comprehensive financial plan will tell you whether or not you’re ready to sell.

“You might need some time for a runway to get your business to the point the sale will generate sufficient money for you to retire without the risk of running out of money in retirement,” Taylor said.

Developing a succession plan is a continuous and collaborative process. HBK Constructions Solutions, in collaboration with HBK Transaction Services, HBK Valuation, HBKS Wealth Advisors, and the professionals of HBK CPAs & Consultants, America’s 46^th largest accounting firm, is uniquely positioned to help you improve your business’s appeal to prospective buyers, determine the value of your business, and develop a financial plan for using the proceeds of your sale to accommodate your personal financial goals. For more information, contact me email at kmelewski@hbkcpa.com; or call HBK Construction Solutions at 330-758-8613.

Contributors to this article:

Kyle Melewski, CPA
Principal | Regional Director, HBK Construction Solutions, Ohio Region

Kyle is the Ohio Regional Director of HBK Construction Solutions, a team of industry-savvy professionals serving the unique business needs of more than 600 construction firms. Kyle provides traditional accounting and tax services, but also services that help contractors improve their financial performance and maximize returns to their shareholders. He uses benchmarking tools to identify areas of strength and weakness, then helps management develop and implement plans to improve areas of weakness. He also helps contractors develop training for their management teams designed to improve internal communication, cash flow, and profitability; assists contractors in the evaluation, development, and application of proper overhead rates; and projects cash flows and develops financial statements that support contractors seeking increases in their credit facility.

Robert J. Zahner, CPA, ABV, CVA, ASA
Principal, HBK Valuation Group

Bob’s public accounting experience includes extensive involvement with businesses and individuals planning for and complying with federal, state, and local tax filing requirements, as well as financial statement analysis for attest. He leverages his years of experience and skills as a Certified Public Accountant to perform valuations of closely held businesses, pass-through entities, C-corporations, professional practices, intangible assets, family limited partnerships, and other entities in various industries.

Keith A. Veres, CPA, CGMA, CEPA
Principal and National Director, HBK Transaction Advisory Services

Keith is a Principal in the Fort Myers, Florida office of HBK, and the National Director of HBK Transaction Advisory Services. He began his accounting career with HBK in 1991. Keith spends the majority of his time helping clients, friends, and associates throughout the HBK family of companies work through their exit strategies.

Brittany Taylor, CFP
Principal, Senior Financial Advisor, HBKS Wealth Advisors

Brittany helps her clients achieve their financial goals by establishing and overseeing a plan of action specific to their unique economic and life situation. She applies a holistic approach to their financial well-being, helping them preserve and grow wealth, developing investment and wealth protection plans that help them attain their families’ objectives. Her client base consists mainly of people in or near retirement and their families. She serves clients in many states from her office in Erie, Pennsylvania

Does your business provide training to its employees in manufacturing or technological skills? If so, TechCred could serve as a valuable program to offset these costs. May 1, 2024, marks the opening of another Ohio TechCred application period to take advantage of these opportunities.

What is TechCred?

In 2019, TechCred was created and funded in the state budget under House Bill 2. The bill allows employers to secure reimbursement for training-related expenses in manufacturing and technology fields of up to $30,000 per round.

Furthermore, employers can choose a training provider that best fits the skills they require for their employees. Universities, community colleges, Ohio technical centers, and private trainers are all eligible options from which to obtain credentials.

How do I apply?

Businesses of all sizes and industries are eligible to participate, as long as they employ Ohio residents. To begin, employers must apply for an Ohio ID at supplier.ohio.gov. Here, they will be assigned a supplier ID number that can be used to begin the TechCred application.

With this supplier ID, businesses can begin their application at techcred.ohio.gov. Applicants will be required to submit their contact information, federal tax ID number, credential being considered for reimbursement (including the credential name, training cost, and training provider), the requested reimbursement amount, number of employees who will earn the credential, and the average wage of employees both before and after earning the credential.

A list of currently eligible credentials can be found at https://techcred.ohio.gov/about/credential-list. However, if yours is not listed here, employers may also apply for credentials not found on this list at the same link under “Credential Not Listed”. This requires the submission of a syllabus and list of skills taught, as well as other attributes of the course in question.

How do I get reimbursed?

After approval, employers have 12 months from the award date for their employees to complete their certification(s). They will ultimately be able to submit proof of credential completion and cost documentation at techcred.ohio.gov to obtain up to $2,000 per credential. Requests for reimbursement should be submitted no more than once a month during the grant period, and no later than six weeks after the credential is obtained. Employers should also provide a status update every six months to reflect whether credential projects are in-process, completed, or cancelled.

Additional details on TechCred are available at https://techcred.ohio.gov/about.

For more information, or to discuss support available for manufacturers, contact HBK Manufacturing Solutions at 330-758-8613 or by emailing manufacturing@hbkcpa.com.

The Florida state sales tax rate on rentals, leases, or licenses to use real property is scheduled to decrease to 2% (from 4.5%) on June 1, 2024. This year’s tax rates reduction follows a reduction in December 2023 that reduced the rate from 5.5% to 4.5%.

The tax on rentals, leases, or licenses to use real property generally applies to commercial office space, warehouses, and self-storage units. The rate reduction does not apply to storage of motor vehicles, boats, or aircraft.

The sales tax rate is based on when the occupant is entitled to occupy the property, not necessarily when the rent is paid.

• Rental charges paid on or after June 1, 2024 for rental periods December 1, 2023 through May 31, 2024 are subject to the 4.5% state sales tax plus any applicable discretionary sales surtax.
• Rental payments made prior to June 1, 2024 that entitle the tenant to occupy the real property on or after June 1, 2024 are subject to 2% state sales tax plus discretionary sales surtax.

The Tax Information Publication No: 24A01-02 issued by the Florida Department of Revenue can be viewed here.

If you have questions on Florida’s tax rate change or other SALT matters, please contact HBK’s SALT Advisory Group at hbksalt@hbkcpa.com.

In the realm of fiscal uncertainties, one glaring example stands out: the precarious state of Social Security. As workers diligently contribute to this safety net, the harsh reality revealed in the 2023 OASDI Trustees Report looms ominously: within a decade, retirement benefits could face a staggering 25 percent reduction. This sobering truth, widely acknowledged, serves as a stark reminder of the fragility of our financial systems.

But amidst this well-known dilemma lies a lesser-known threat, a new contender vying for a slice of your hard-earned income: state-based long-term care programs. While Social Security’s woes may seem daunting, the cost-benefit dynamics of state initiatives paint an even bleaker picture. Following the example set by the State of Washington, nineteen states, including New York, are contemplating implementing a tax on individuals who are not covered by a qualifying long-term care insurance policy.

For high earners in New York, this program appears a losing proposition from the outset. Unlike Social Security, where eventual benefits may outweigh contributions over time, the New York State LTC Trust Program presents a starkly different scenario. As we delve deeper into this fiscal landscape, it becomes evident that navigating these treacherous waters requires astute planning and proactive measures.

New York’s proposed program

New York has proposed a Long-Term Care Trust Program to address the issue of long-term care insurance through a mandatory payroll tax. Washington was the first state to adopt such a plan; New York and other states including California, Illinois, and Pennsylvania are considering similar programs. 

The New York proposed legislation includes a new payroll tax on employees to be paid into the state’s long-term care fund. This is an employee tax, though it will require administration by employers to withhold the taxes. Self-employed individuals could voluntarily elect the coverage and pay the tax.

In Washington state, employers scrambled to find a long-term care solution to help employees avoid the tax and receive a more benefit-rich option using employee-funded, payroll-deducted solutions.  The time to consider possibilities is now.

The effective date of New York’s pending payroll tax, which may range from .5 percent to 1 percent, is yet to be determined, as the proposed legislation has not yet been passed. 

Opt-out requirements

Employees can opt out of the state coverage and the payroll tax by proving they have their own long-term care coverage. In Washington state, people were able to purchase private long-term care policies after the statute was passed. However, the proposal in New York would require that private long-term care insurance would have had to be purchased prior to January 1 of the year the law is passed. As such, if the long-term care law is passed in 2024, private long-term care insurance would have had to have been purchased before January 1, 2024. If the law is passed in 2025, private insurance could be acquired before January 1, 2025.

What are the benefits?

The program would pay a lifetime benefit cap of a hundred dollars a day for one year ($36,500). The payments could be used for such items as:

• adult day care
• memory care
• adaptive equipment
• environmental modification
• personal emergency response system
• home safety evaluation
• respite for family caregivers
• home delivered meals
• transportation
• dementia support
• education and consultation
• eligible relative care
• assisted living
• adult family home services
• nursing homes

Benefits would be paid directly to a registered long-term care provider. Benefits would not be paid to the ill individual. Family members who provide approved personal care services would be eligible for payment. Benefits would not be considered income or resources for state-financially tested programs such as Medicaid.

The lifetime benefit of $36,500 is modest, only a fraction of the cost for the most seriously ill. The benefit is most appropriate for those in the early stage of illness when the needs are less. High-wage earners could pay more in payroll tax than they could receive in the lifetime benefit. Someone who earned $600,000 per year and paid $45,000 in tax over a 10-year period (assuming a .75 percent tax rate) could receive a lifetime benefit of no more than $36,500, a losing proposition even before considering lost opportunity costs. 

Private LTC

If the states are going to impose an LTC tax with a one-size-fits-all plan, why not consider putting your own plan in place, one you can customize to fit your employees’ needs, one that allows them to opt out of the state tax in the process? Advantages include:

• More options: Linked benefit, traditional, and life insurance riders are all choices when considering a plan for LTC. These plans offer a wide-range of benefits, making it possible to fit most budgets.

• Better control: Most private plans offer home and facility care, giving policyholders flexibility when it comes to where and when they receive care. Providers will be more willing to work with clients with LTC coverage.

• Premium guarantees: Linked-benefit plans offer guaranteed premiums, while traditional LTC premiums are guaranteed renewable. This means premiums can’t be changed when a policyholder’s health changes. And many policies waive premiums when a policyholder goes on claim.

• Inflation protection: Many plans offer the ability to increase benefits in an effort to keep up with inflation.

Conclusion

As stewards of our clients’ financial future, our team stands ready to help you navigate these issues to avoid or mitigate costs that do not provide reasonable benefits. We are able to assist in determining what options are available. Please contact us to discuss your options.

In recent legislation, Indiana eliminated the transaction count from its sales tax economic nexus threshold. The change is retroactive to January 1, 2024. The economic nexus threshold in Indiana was $100,000 in gross revenue or 200 or more separate transactions. Going forward, only the $100,000 in sales for a calendar year will create an economic nexus for a seller without a physical presence in Indiana.

Indiana joined a growing number of states (Louisiana, South Dakota, and Wyoming in the last year) eliminating transaction counts from sales tax economic nexus thresholds. The elimination is a positive change for remote sellers of low-value items, such as clothing, that trigger nexus based on their transaction count but who have relatively minimal total sales into a state.

If you have questions on sales tax economic nexus or other SALT matters, please contact the HBK SALT Advisory Group at hbksalt@hbkcpa.com.

Manufacturers and wholesale distributors have been no strangers to supply chain crises over the past several years. Disruptions caused by pandemic-related business shutdowns, the Suez Canal blockage, and the Panama Canal drought have impacted manufacturers, distributors, and other businesses globally. Regional events, including Hurricane Idalia, also have created more localized disruptions.

Yet, another recent incident could also impact some areas of the supply chain. After the Francis Scott Key Bridge tragically collapsed last week, marine traffic around the Port of Baltimore stalled. Ships currently in the port will likely remain in place for the time being, causing delays for goods carried on these vessels. Moving forward, importers should remain vigilant regarding deliveries of cars, light trucks, farming equipment, and construction equipment, all of which arrive in high volume at the Port of Baltimore. Other goods including sugar, gypsum, and forest products could also be affected.

In the short term, it is expected that the port can reopen after the wreckage and debris is cleared. Due to available capacity, it is likely that other East Coast ports will handle the increased volume. This diversion may mitigate significant delays. Fortunately, it is anticipated that the Port will resume full operations within a matter of weeks, despite the bridge being out of service for several years if not a decade.

The bridge closure will likely impact many companies along the East Coast. Many alternative routes have size or material restrictions, which will make large loads or hazardous materials more difficult to transport. Further, companies with warehouses or distribution centers located in or around the Baltimore area may be particularly affected by land-based transportation challenges.

As a result, many currently predict that the most significant impact to the entire supply chain will be cost. Imports may be diverted to other ports, lengthening the transportation time for these goods to reach their destination. Trucking companies may need to prepare for significant delays and lengthened driver times; both the inability to predict new route traffic and the lengthened transportation time will undoubtedly increase costs. Further, some businesses that rely on these goods may increase inventory and will look to increase prices in order to cover heightened carrying costs.

With supply chain disruptions becoming more common, manufacturers and wholesale distributors can take five actions to mitigate their risk:

1. Assess any potential short-term impacts from the Francis Scott Key Bridge collapse. This includes delays related to any imported products as well as delays that your suppliers may experience related to their imports. If you have significant import exposure, consider whether an onshoring option can provide resiliency for your supply chain.
   
   
2. Prepare yourself for cost increases in the short term. As inflation continues at a higher-than-normal pace, businesses must be prepared to ensure they can actively manage their costs to remain profitable and stable. Products not directly impacted by the bridge collapse may also be affected since land transportation is likely to be challenged for some time.
   
   
3. Talk with your suppliers. Even if you do not directly import, consider meeting with critical suppliers to ensure you understand vulnerabilities that can affect your business. Discuss the impact of the Francis Scott Key Bridge collapse on imports as well as their expectations for delivered lead times and costs over the next 12 months.
   
   
4. Continue to re-evaluate your supply chain. Many organizations revisited their supply chain after the pandemic, seeking alternative suppliers and modest levels of inventory after years of a just-in-time approach. If you have not continued to review your supply chain, consider doing so. Ensure that weaknesses are addressed and contingency plans are made in case a key supplier cannot deliver to you for any reason.
   
   
5. Prepare for the unexpected. Over the first quarter of the century, businesses have experienced several unexpected events. Besides the Francis Scott Key Bridge collapse, economic cycles, geopolitical tensions, the pandemic, acts of terror, and weather events have occurred, which are situations that business owners cannot control. Having basic protections, including maintaining adequate cash availability, using a financial budget, and ensuring you have and review timely-prepared, accurate financial statements on a regular basis can help you ensure that you are financially stable and able to weather future issues.

To discuss your supply chain preparedness, financial position, or other aspects of your business, please contact HBK Manufacturing Solutions at 330-758-8614 or manufacturing@hbkcpa.com.     

Have you worked overseas or moved to the U.S. from another country where you duly earned pension benefits or deferred compensation?  Do you also have a tax-free savings account or life insurance policy in a foreign country?  Your answer may be, “Sure, yes, but what does it have to do with foreign trusts?” That’s a valid question. After all, what do trusts have to do with pensions plans? Keep reading to find out more about U.S. taxation of foreign pensions and retirement accounts.

Migration among countries and continents has never been at levels in the history of humanity as high as today. We move seeking a better life, greater opportunities, and more freedom. Amid all this, taxation is not always a priority concern. Hence, tax is sometimes overlooked and falls through the cracks until a next deadline.

Most commonly, taxes on income from the likes of salaries and investments are remembered first. However, in addition to taxes on income items, the IRS requires the disclosure of foreign assets, including foreign pension plans and other deferred compensation arrangements.

Generally, foreign pension and retirement plans, including certain annuity plans, life insurance policies, and other tax-deferred savings accounts are treated as foreign grantor trusts.

What is a Trust?

In her article “Do You Have a Foreign Trust?” recently published in the Naples Daily News, Principal and Chair of the HBK Tax Advisory Group Amy Dalen defined “trust” as “any arrangement where an individual (trustee) holds title to property for the benefit of others (the beneficiaries).” A trust is defined as a “foreign trust” if a court outside the United States exercises primary supervision over the administration of the trust and no U.S. persons are authorized to control all substantial decisions of the trust. Foreign trusts can be grantor and nongrantor trusts. A trust is a grantor trust when a U.S. citizen is treated as the owner of the trust for income tax purposes. A nongrantor trust, on the other hand, is treated as a separate taxpayer from the grantor and beneficiary. The U.S. foreign reporting requirements differ substantially from other foreign trusts when a U.S. citizen is treated as the owner of either type of trust.

Trusts, Pensions, and Taxation

The IRS generally requires foreign grantor trusts to file two forms: Form 3520, Annual Return to Report Transactions with Foreign Trusts and Receipt of Certain Foreign Gifts; and Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner. There are significant penalties, a minimum of $10,000, for failing to file complete and accurate Forms 3520 and 3520-A. The IRS can reduce or eliminate the penalty if the U.S. person can demonstrate reasonable cause for failing to file the required form(s).  

Now let’s turn to the role trusts play in defining pension plans. U.S. tax regulations distinguish between qualified and non-qualified pension plans. Consider a 401(k) as a qualified pension plan. Generally, a qualified pension plan is a trust created or organized in the United States and forming part of a pension plan of an employer for the exclusive benefit of their employees or their employees’ beneficiaries.¹ By default, then, foreign pension plans are not qualified because they are not organized in the United States, the most significant difference being that contributions to qualified pension plans are deductible while distributions are taxable².

Therefore, even though a contribution to a foreign pension plan is tax-deferred in a foreign jurisdiction, it could be taxed in the United States depending on the terms of pensions plan scheme. Moreover, since the U.S. person who contributed to the foreign plan is treated as the U.S. owner and beneficiary of a pension plan organized outside of the United States, the pension plan would generally be treated as a foreign grantor trust.

Thus, foreign pensions and other deferred-compensation accounts should be carefully evaluated by a tax advisor, as many plans can be treated as grantor trusts for U.S. tax purposes, bringing on a multitude of additional U.S. foreign reporting requirements. If such additional filings are not timely identified and complied with, the taxpayer may be subject to harsh penalties.

Furthermore, the investments held within a pension plan may also fall under the definition of Passive Foreign Investment Companies (PFICs). These are pooled investments that are registered outside the United States. Thus, in addition to Forms 3520 and 3520-A, the taxpayer might also be required to file a Form 8621, Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund, for each PFIC held in the pension plan. Form 8938, Statement of Specified Foreign Financial Assets, and FinCEN Form 114, Report of Foreign Bank and Financial Accounts might also need to be filed. Each form carries hefty penalties for non-compliance.

It is important to know that the U.S. tax treatment of foreign pension plans can vary from country to country, depending on the tax treaty or social security totalization agreement between the United States and a particular foreign jurisdiction. 

Social Security System and National Pension Schemes

Government-sponsored pensions such as Social Security System or national pension schemes are public pensions. These are usually mandatory for all workers and funded by the employees, their employers, and sometimes governments. There are other characteristics that also need to be evaluated and depend on the country of origination. Where such characteristics exist, it is possible that even government-mandated retirement accounts can be treated as grantor trusts for U.S. tax purposes. However, it is also possible that a foreign government pension would have no specific reporting requirements in the United States until there are distributions. A careful analysis of the pension plan and tax treaty, if such exists between the countries, needs to be performed to determine treatment for U.S. tax purposes.

Employer-Sponsored Pensions

Foreign employer-sponsored pension plans are retirement plans that are established and maintained by employers for the benefit of their employees. The most common type of employer plan is a defined contribution plan. As with a U.S. 401(k) plan, foreign employer pension plans are generally funded by the employees while employer pension contributions may be either mandatory or optional depending on specific pension agreement and foreign country regulations. Unlike contributions to a 401(k) plan, no deduction is allowed for the employee’s portion of foreign pension contribution in the United States; it is treated as additional income for U.S. tax purposes. Furthermore, the employer’s portion of contributions may also be taxable in the United States in the current period.

Additionally, these plans are usually treated as grantor trusts for U.S. tax purposes, and therefore subject to foreign grantor trust treatment and potential PFIC reporting requirements.

Self-Funded Retirement Savings Accounts

Individual retirement accounts and retirement savings accounts are usually funded solely by the taxpayer. In absence of a tax treaty or other IRS-provided guidance, these types of foreign accounts are more likely to be classified as foreign grantor trusts for the U.S. tax purposes.  While this could be a tax-deferred plan in a foreign country, it is generally not in the United States where the foreign grantor trust is deemed an extension of a grantor. Hence, any income and growth in the plan is taxed currently. Just like foreign employer-sponsored defined contribution plans, these plans are subject to a myriad of tax filing requirements in the United States.

Other Financial Assets

Other financial assets that can result in foreign grantor trust treatment include tax-free savings accounts, certain types of life insurance policies, and other deferred compensation plans. If you are planning to immigrate to the United States, we strongly recommend pre-immigration planning to identify your potential U.S. tax reporting requirements. If you are a U.S. citizen or resident who has lived and/or worked in a foreign country, have pension plans or made investments in a foreign country, or even has family in a foreign country, you should speak with a professional familiar with international tax reporting to ensure you are in compliance with the U.S. foreign information reporting requirements.

HBK CPAs & Consultants can help you with planning and tax compliance. Please contact an HBK tax expert team for a consultation.

¹IRC §401(a)

²IRC §§401(a), 402(b)

HBK CPAs & Consultants (HBK) again ranks among the Top 50 U.S. accounting firms according to the latest study by Accounting Today magazine. In its 2024 study, the magazine also recognizes HBK as a “top regional firm,” eighth among firms in the magazine’s “Great Lakes” region, which includes Illinois, Indiana, Michigan, and Wisconsin as well as Ohio.
 
“That accounting is changing fast is something we’re all aware of on a daily basis— the sheer volume of new tools, new challenges, and new opportunities that emerge every day is a constant reminder of it,” the magazine’s editors characterized the preceding year.
 
“The accounting profession as well as the rest of the business world continues to undergo a digital transformation that is already bringing dramatic changes to the way we do business, the way we serve our clients,” noted HBK CEO and Managing Principal Christopher M. Allegretti, CPA. “Remaining relevant as well as competitive requires finding new and better ways to support our clients and their businesses. That we continue to rank among the nation’s largest and most respected accounting firms is testimony to our commitment to that objective.”
 
The annual ranking of the leading national and local firms is based on annual revenue. HBK has been included in the Accounting Today Top 100 for more than a decade.
 
HBK CPAs & Consultants is a multi-disciplinary financial services firm providing small to mid-market businesses and their owners and operators a wide range of financial solutions.

Highlights of the March 2024 edition of the HBK Risk Advisory Services webinar series hosted by William J. Heaven, CPA/CITP. CISA, CSCP, Senior Director, HBK Risk Advisory Services.

Watch on Demand.

Is your company currently managing vendor or third-party risk?

• Only 30 percent of companies are managing risk of at least half of their third-party relationships.
• 77 percent of executives say they need to overhaul their risk management program.
• 71 percent of this webinar’s attendees responded that they are not currently managing third-party risk.
• 52 to 54 percent of cyber breaches are caused by a third party.
• 46 percent of all beaches impact businesses with fewer than 1,000 employees.
• Third-party risk continues to rise:

Email/ phishing/supply chain threats (SolarWinds supply chain hack: hackers made it look like the firm was sending messages to clients that they needed updates and trusting clients accepted them thinking they were legitimate.)

How do vendors rate?

Are they meeting their obligations?

• Contractual
• Security
• Privacy

Attack vectors include:

• Ramsomware is about 25% of breaches
• Undermining code signing, as in supply chain hacking (looks like the information is coming from a trusted source)
• Compromising open-source code (many people are relying on open sources)

Zero-day vulnerability: where the bad guys have access before you notice. Cybersecurity hygiene is the best defense against zero-day vulnerability.

Who owns vendor risk?

There is confusion about responsibility: Cybersecurity is a business-level risk that can result in a tug of war between information security and procurement.

• Procurement is responsible for onboarding new third parties.
• Information security is responsible for data privacy, data protection, and information security protection.
• Express the risks and let procurement make the decision of whether or not to engage the vendor.

Third-party risk management steps:

• Discover: understand how to categorize your vendors.
• Analyze how a vendor will work into your environment. (Triage: a series of high-level questions as to how you will work with a vendor; higher risk based on whether they will take possession of your data or have access to your computer system; determine possible negative impact)
• Based on the analysis, quantify the risk.
• Prioritize which will be the most or least risky vendors.
• Continuous monitoring: most important to security; maintaining an understanding of the risk level of a vendor, whether it’s changing.
• 88 percent of webinar attendees answered they had been impacted by third-party risk.

Third-party risk on the rise

• Text messaging risk has increased.
• Third-party breach costs are rising: by about 25% and getting close to an average of $5 million per breach.
• 54 percent of organizations have experienced a breach due to a third party.
• Almost 60 percent of businesses hit with a cybersecurity breach go out of business within a year.
• Rating vendors provides an opportunity for a new vendor to protect against exposure.
• Vendors doing business in various states must adhere to security and privacy rules in those states.

Information sources:

• International Association of Privacy Professionals
• California Consumer Privacy Act: the regulation in the U.S. that is most often referenced

Where to own the risk?

• Someone has to own it, and not only IT security and procurement
• Educate employees how to take responsibility at the business level

Suggestions

• Establish a program of governance: Put things in place to make people aware of the risks.
• Use IAPP.org to monitor what’s new in terms of risk and privacy.
• Get vendor commitments.
• Sign up with FBI for hacking updates.
• CISA.gov: suggestions for security awareness programs.
• Any program needs the support of and adherence by the company’s highest level of management.

Gaps/mature characteristics

63 percent of webinar attendees responding answered that their gap in performing third-party risk assessment is a lack of personnel; 25 percent said third parties are too difficult to assess.

Biggest gaps:

• Inadequate coverage of third parties
• Assessment backlog
• Lack of design/prioritization (Start with highest risk.)
• Difficulty of assessing vendors

Mature program characteristics:

• Automation: used to continuously monitor
• Assessment exchanges: sharing incident information
• Artificial Intelligence: AI to be available soon to check vendors’ security, but have to be careful about providing data to AI.

If you don’t have a third-party risk management program yet, consider getting something in place.

A Single Audit is required when a non-federal entity expends $750,000 or more in federal awards during its fiscal year. The awards can be direct (straight from the federal government) or indirect (from another non-federal entity). Because it is based on total grant expenses for one year (not per grant), not every company that needs to perform a Single Audit needs one every year. However, increasingly many companies have needed their first Single Audit in recent years, due to increased federal grant funding related to the COVID-19 pandemic.

Following are some key facts about Single Audits, including requirements and changes effective in accordance with the 2024 revision to Government Auditing Standards (also known as the Yellow Book) and the data collection form:

• Non-federal entities, organizations that carry out a federal award as a recipient organization or subrecipient organization, include state and local governments, nonprofit organizations, Native American tribes, and institutions of higher education.

•  In a financial statement audit, the auditor or auditors provides their opinion on whether the financial statements as a whole are presented fairly. The purpose of the Single Audit is to determine if award recipients comply with direct and material compliance requirements for each major program. Federal agencies use Single Audit reports and findings to address problems at the grantee level or to implement changes or improvements to federal programs. It also provides assurance about the recipients’ internal controls over compliance.

• Single audits involve three layers of accounting requirements: Generally Accepted Auditing Standards (GAAS) requirements, Yellow Book requirements, also known as the Generally Accepted Government Auditing Standards (GAGAS), and Uniform Guidance requirements. There cannot be a single audit without the audit also being done under GAGAS. There can be an audit under GAGAS that does not include a single audit.

• The Single Audit Act Amendments of 1996 (Single Audit Act) were enacted to streamline and improve the effectiveness of audits of federal awards expended by states, local governments, and nonprofit entities (referred to as “non-federal entities”), as well as to reduce audit burden. The Single Audit Act requires Single Audits to be conducted by an independent auditor.

• The Single Audit Act gives the Director of the Office of Management and Budget (OMB) the authority to develop government-wide guidelines and policy statements on performing audits to comply with the Act. The most recent OMB regulation issued for this purpose is known as “Uniform Guidance”; it includes uniform cost principles and audit requirements for federal awards to non-federal entities and administrative requirements for all federal grants and cooperative agreements.

• The OMB sets the policy for single audit submissions and their deadlines. The audit package and the data collection form must be submitted to the Federal Audit Clearinghouse (FAC) within the earlier of 30 days after receipt of the auditor’s report(s) or nine months after the end of the audit period, whichever comes first. However, the OMB is waiving the 30-day deadline for 2023 submissions. For 2023 submissions with fiscal periods ending between January 1, 2023, and September 30, 2023, requirement 2 CFR 200.512(1) stating that Single Audits are due to the Federal Audit Clearinghouse 30 days after receipt of the auditor’s report(s), is waived. These audits will be considered on time if they are submitted within nine months after their fiscal period end date.

• As of September 30, 2023, management and governance of the FAC, where federal grant audits are submitted, is transferred from the Department of Commerce’s Census Bureau to the General Services Administration (GSA). As such, the GSA is the new repository for the collection and posting of Single Audit information as of October 1, 2023; it will accept Single Audits with fiscal periods ending 2023 and later. To submit or review a Single Audit, go to the fac.gov homepage and sign in using login.gov. 

• Once you submit a Single Audit package, you cannot make further changes. What you have submitted is what will be available for review via the FAC’s audit search tool.

• On February 1, The Government Accountability Office (GAO) released the Government Auditing Standards 2024 Revision, which replaces Chapter 5 of the 2018 revision with a new Chapter 5 titled, Quality Management, Engagement Quality Reviews, and Peer Review. The 2024 revision also adds application guidance to Chapter 6, Standards for Financial Audits, to provide clarity as to when the concept of reporting key factors in audit matters, previously introduced into the AICPA auditing standards framework, might apply for financial audits of government entities and entities that receive government financial assistance. There are no other changes to the remainder of the Yellow Book.

• Government Auditing Standards 2024 Revision is effective for financial audits, attestation engagements, and reviews of financial statements for periods beginning on or after December 15, 2025, and for performance audits beginning on or after December 15, 2025. A system of quality management for financial reporting that complies with Government Auditing Standards must be designed and implemented by December 15, 2025. An audit organization should complete its evaluation of the system of quality management by December 15, 2026. Early implementation is permitted.