General Practice, Solo & Small Firm DivisionBest of ABA Sections
Real Property, Probate & Trust Law
Qualified Retirement Plans for the Small Business Owner
Irwin N. Rubin and William Miller
Qualified retirement plans offer advantages for an owner of a small business. The goal is to structure a qualified retirement plan that will maximize the contribution for the owner while keeping common law employee costs at a minimum. Numerous planning techniques are available that will attain such goals for some clients, especially older owner/employers who have not yet accumulated large retirement plan assets.
Tax Advantages. The tax deferral advantages may continue not only beyond the owner's retirement but also beyond the owner's death, when those assets are rolled into an IRA by a surviving spouse. The income tax advantages available to the business owner under a qualified retirement plan are:
• deferral of tax on otherwise taxable compensation until its distribution;
• deduction of the deferred compensation currently; and
• income tax exemption for plan earnings.
Although qualified retirement plan assets will be included in the owner's estate upon death, the deferral of income tax for both the owner and the owner's heirs produces significant financial advantages.
Distributions. A participant or a participant's spouse may, to a large extent, control the timing and amount of taxable distributions by rolling over the taxable part of a qualified plan distribution to an Individual Retirement Account (IRA) or to another qualified plan. Qualified retirement plans must generally give participants the ability to roll over pretax distributions--other than required minimum distributions beginning at age 701/2 or annuity payments--directly into another qualified retirement plan or IRA. Additional taxes apply when (1) distributions are taken before age 591/2 ; and (2) certain minimum amounts are not distributed after age 701/2.
Qualified Retirement Planning. A qualified retirement plan should attempt to maximize tax deferrals for business owners and minimize the costs of the retirement plan for other employees.
• Defined benefit plan. A defined benefit plan provides for a definitely determinable benefit at retirement. For example, a defined benefit plan may provide a benefit equal to 25 percent of an employee's compensation payable in monthly installments beginning at age sixty-five. Compensation taken into account for any employee under a defined benefit plan or defined contribution plan (discussed below) cannot in 1997 exceed $160,000. Actuarial calculations are made annually to determine the necessary contributions so that the plan has sufficient funds to satisfy the plan's obligations. Generally, for an older business owner, a defined benefit plan will generate large contributions and a large tax deduction. If the employees are also older, high contributions will be necessary to fund the staff's benefits. Contributions under defined benefit plans are not limited to $30,000 as they are in certain defined contribution plans. The law requires that certain minimum funding contributions be made to defined benefit plans regardless of the profits of the business. Distributions under these plans require spousal consent. Generally, IRS regulations require that the same benefit formula apply to all employees.
• Defined contribution plan—profit-sharing plan. A profit-sharing plan generally provides for discretionary employer contributions not to exceed 15 percent of employee compensation. The amount payable at retirement depends on the amount of the yearly contributions and the investment experience of the fund. These contributions are deductible by the employer. Contributions are generally allocated to employees in proportion to compensation. Compensation taken into account for any employee cannot in 1997 exceed $160,000, so the maximum contribution should not exceed $24,000 (15% of $160,000). Also, contributions do not have to be made each year as with a defined benefit plan or money purchase pension plan. Generally, distributions from a profit-sharing plan are not subject to spousal consent.
• Defined contribution plan—money purchase pension plan. A money purchase pension plan provides for a fixed rate of contribution. For example, this plan may provide a contribution of 25 percent of compensation for each employee. The law requires the employer to make the fixed contributions each year regardless of profits. Because the contribution rate is the same for everyone, the IRS nondiscrimination rules are satisfied. Distributions under a money purchase plan are subject to spousal consent. The employer receives a tax deduction for the contributions.
• Integration. Another version of a profit-sharing or money purchase plan is an integrated plan. In this plan, the contribution is coordinated with the Social Security taxable wage base. This permits a slightly greater contribution as a percentage of salary for employees earning in excess of the Social Security taxable wage base. An example of this formula would be a contribution by an employer for each employee of 10 percent of compensation and an additional contribution equal to 5.7 percent of the amount by which the employee's compensation (up to $160,000) exceeds the Social Security taxable wage base for the year. Thus, an employee with compensation of $160,000 would receive a 1997 contribution of $21,392 (10% of $160,000 plus 5.7% of $94,600 ($160,000 — $65,400)). An employee earning $30,000 would receive a $3,000 contribution.
• 401(k) plan. This is a plan under which employees can elect to reduce a portion of their salaries and have the amounts contributed to the plan. In this plan the contribution is coming from the employee's salary. The employee is not taxed on the amounts contributed to the plan and his or her W-2 income is reduced by the amount deferred into the plan. The employer receives a tax deduction for the salary reduction contribution. In 1997, the limit for a salary reduction contribution is $9,500. For this plan to work, the salary reduction amounts of highly compensated employees (HCEs) (including owners) can be slightly greater as a percentage of pay than the non-HCE salary deferrals, but cannot exceed the amounts prescribed under the Code.
• New comparability plan. This is a defined contribution plan that can be structured to provide significantly greater contributions for business owners who are older than their employees. The disparity in contributions in favor of the HCEs compared with the non-HCEs can far exceed any disparity in contributions for the HCEs permitted under profit-sharing, money purchase, 401(k) or integrated plans. Under this variation, greater allocations are permitted because the plan can be treated like a defined benefit plan. The contribution allocations for each participant are projected to a testing age (usually 65) and converted into an annual benefit. The annual benefit is divided by current compensation to obtain a benefit percentage. The benefit percentages for the HCEs are compared to the benefit percentages of non-HCEs in testing for nondiscrimination. As long as the plan satisfies the IRS rules for nondiscrimination based on the benefit percentages, disproportionately greater contributions for the older business owner are acceptable.
Conclusion. These few examples provide concepts that planners may use to take advantage of qualified retirement plans to optimize and customize appropriate plans for their small business owner clients.
Irwin N. Rubin is counsel in Danziger & Markhoff LLP in White Plains, New York. William Miller, M.S.P.A., M.A.A.A., is chief actuary for Danziger & Markhoff LLP in White Plains, New York.
This article is an abridged and edited version of one that originally appeared in Probate and Property, January/February 1997 (11:1).