Business owners are notorious for ignoring their persona finances. Not that they don't care about money: They are in business, after all, not in charity work. But managing their money? That's a job they leave to the accountants. Or to financial planners. Or to no one.
Lynn Hopewell quarrels with this attitude only in the last instance. Hopewell and her partner, Donald Rembert, run Hopewell Rembert Advisors Inc., a feeonly advisory firm in Falls Church, Va. They count several business owners among their clients, and are more than willing to do the financial-management work the owners don't have the time or inclination for. But a lot of entrepreneurs haven't found the time to sit down with an adviser to map out goals and strategies for the future. And those who haven't, Hopewell says, are likely to find themselves falling into several well-worn money traps -- "mistakes we see over and over again among our new clients."
What are these mistakes? Talking with INC. senior editor John Case one day in December, Hopewell was happy to elaborate.
INC.: Lawyers recommend legal advice, accountants recommend accounting services -- no doubt you're going to tell us is that we all need a financial plan.
HOPEWELL: No surprise. But people aren't going to put together a financial plan just because some planner says they should. Most people already think they need a plan. They just haven't gotten around to it yet.
INC.: Let's grant that a little financial planning goes a long way. But is it really so urgent?
HOPEWELL: As long as you procrastinate, things will catch you by surprise. For example, thousands of people have been caught this year by the alternative minimum tax. When the AMT cuts in, all your tax shelters become suddenly ineffective. Then, too, everybody in a high tax bracket is a prime target for salespeople peddling investments, insurance, and every other kind of financial ware. Without a plan, you're vulnerable to the first salesperson with a persuasive pitch. You react rather than act, and you wind up with fragmented and uncoordinated finances.
INC.: Give me an example of the financial traps the procrastinating business owner is likely to fall into.
HOPEWELL: An obvious one is failing to take full advantage of the corporate pension plan. A lot of the chief executive officers we talk to simply don't understand it, so they don't realize its potential. In fact, it's probably your most valuable wealth-building device.
INC.: The very language of pension plans -- defined benefits, defined contributions, and so forth -- is confusing enough.
HOPEWELL: Yes, but that confusion can cost you money. Most of our clients, for example, have thought they were limited to $30,000 a year in contributions. That is not true. We have numerous clients who are drawing six-figure salaries and putting another six-figure sum into their retirement plans.
INC.: But retirement plans have to cover a lot of people other than the CEO.
HOPEWELL: Of course. By the same token, though, a lot of owners overestimate the extent of employee benefits. Employees don't get a fully vested claim to the amount the company contributes until they retire. In most cases, employee turnover cuts down on the cost.
Look at it this way. The retirement plan is the perfect tax shelter: It produces a one-to-one write-off, and it can be invested in essentially no-risk vehicles. No one should be involved in ordinary tax shelters until he or she has maximized use of the retirement plan.
INC.: Surely most high-bracket taxpayers need some other kind of shelter as well.
HOPEWELL: Maybe. Too many people are to dazzled by the prospect of saving 50? in taxes that they spend a dollar to do it. Taxes are never forgiven; they are only deferred. If you don't get real economic benefits from your shelter, you may be left with a tax obligation and no money to pay it.
INC.: Any handy rules of thumb for separating the wheat from the chaff?
HOPEWELL: Try this on the next taxshelter salesman who calls you. Ask him, for the deal he's pushing, "What is the projected aftertax adjusted annual internal rate of return on investment, using a safe 8% rate for negative cash flows and a reinvestment rate of 15% for positive cash flows?"
INC.: We might let our accountant ask that one.
HOPEWELL: Fine. But if the salesman doesn't know the answer, or won't get it, don't do business. If he does know the answer but it's less than 20%, don't do business unless you know something special.
INC.: What do you think of leaving money in the company, rather than taking out so much compensation that you need tax shelters?
HOPEWELL: A lot of businesspeople overlook the advantages of this strategy. You can leave money in the company at a tax cost of only 15% on the first $25,000 and 18% on the next $25,000. And at sale or liquidation, the money comes out at capital-gains rates.
INC.: Suppose you need the money in the meantime?
HOPEWELL: Borrow it. If your adviser says you can't do it -- and many say just that -- fire your adviser. There's no law that says your company can't lend money to you. You just have to dot all the i's and cross all the t's.
INC.: What about insurance? Most people, if they think about it at all, can't decide if they have too much or not enough.
HOPEWELL: Where life insurance is concerned, most people don't have enough when they are young. When they are older, they have too much. If you have children, for example, $500,000 in insurance is not too much to ensure their security and education if you die. When the children are grown, insurance needs fall drastically.
Insurance is a wonderful invention, but it pays to remember that most insurance needs are temporary. Ideally, as you build your estate, your insurance needs fall to zero. And by all means, use term insurance. You can afford all you need, and you're not paying for the savings plan that's built into whole-life policies.
INC.: Why not put whole-life insurance into the retirement plan, and thereby take advantage of tax deductions on the premiums?
HOPEWELL: This strategy is generally a mistake. We have seen many illustrations -- all provided by insurance salespeople -- that apparently prove it is a good idea to put insurance in a corporate plan. But when we revise the assumptions to reflect reality -- comparing the whole-life plan, for example, to the lowest-cost term insurance on the market -- the answer comes out, "Don't do it." Buy term insurance, and buy it yourself.
INC.: Are there any other insurance mistakes?
HOPEWELL: People expect to die, so they have life insurance. But they have difficulty envisioning themselves disabled. Statistically, disability before age 65 is more likely than death before age 65. You should really have disability insurance even before you have life insurance. If you die, at least you stop eating.
INC.: You're saying that business owners don't have disability insurance at all?
HOPEWELL: You'd be surprised at the number who neglect it. But even people who do have policies should look them over. Most policies over three years old can be improved. Be sure, for example, that your policy has inflation protection, and that it pays for partial or residual disability without requiring total disability first.
INC.: Should the company buy the policy, or should the CEO buy it personally?
HOPEWELL: If you pay for it personally and then are disabled, the income you get is tax-free. If the company pays for it, the premiums are tax-deductible -- but any income you realize is taxable. Rather than make a once-and-for-all choice between these alternatives, make the decision from year to year, since the only thing that matters is who paid the premium in the year of disability. At the end of your premium year, look down at your feet. If you can still stand, pay for the new year's premium yourself, and get your company to reimburse you for the previous year's.
INC: Death, disability -- business owners probably don't want to think about such matters any more than everyone else does.
HOPEWELL: Probably not. But when you own a business, there's more at stake. A lot of enterpreneurs, for example, put off dealing with what will happen to the company when they retire or die. That can rob their heirs of a significant portion of the business's value. It may even deprive the owners themselves of retirement security. Then, too, business owners frequently overlook key elements of estate planning.
INC.: Such as?
HOPEWELL: Such as the use of an intervivos trust. The words may sound like legalese, but an intervivos trust is an ideal way to avoid probate, and to provide for asset management if you are disabled. Ask your lawyer. But don't let the lawyer talk you out of it without compelling reasons. Too many attorneys seem to have a vested interest in the probate process and are reluctant to support a device that gets you out of probate.
INC.: We haven't talked much about investments. Maybe that's because business owners don't need as much advice on the subject.
HOPEWELL: Most entrepreneurs know their own business, but they don't necessarily approach investing in a sophisticated manner. They buy individual stocks, for example, instead of a good no-load mutual fund. Maybe they secretly yearn for the big killing, but it's an unrealistic hope.
INC.: A lot of businesspeople stay out of the market altogether, and put their money into real estate instead. Does that make sense?
HOPEWELL: So long as they don't have too much money in unimproved land. Ordinarily, unimproved land is a lousy investment. It pays off only if you experience fairly rapid appreciation, say 10% to 15% a year. Most people are better off selling unimproved land and putting the money into improved property that earns income while it appreciates.
Another suggestion: Don't overlook the value of second mortgages. We have client pension funds that now earn an average of 16.5% using fully secured second-mortgage notes.A return like that, with a high degree of safety, is something the stock market can't begin to match. My only word of caution is that you need expert advice to evaluate mortgage notes properly.
INC.: With inflation down, isn't real estate losing some of its allure?
HOPEWELL: Everybody seems to think that at 5%, inflation is under control. That's baloney. At 5%, the purchasing power of your money will fall by half in just 14 years. Everyone needs some equity investments that will grow with inflation. We like real estate.