Opportunities for businesses and professionals in transition to “double-up” on their annual contributions…
In today’s economy, it seems as though professionals and small-business owners are constantly changing the form in which they do business (e.g., going from proprietorship to corporation), leaving their current groups of business associates, or forming new business alliances. Although most of these business transformations or transitions are spurred by business and tax considerations not related to retirement plans, these types of changes often provide professionals and small-business owners with special retirement plan opportunities.
This article will explain how the tax rules governing contributions to defined contribution retirement plans (i.e., profit sharing plans, 401(k) plans, money purchase pension plans, and target benefit plans) will often permit you to make more than one contribution to your retirement plans during the year you are undergoing a business transformation or transition.
Know The Rules
To explain what is going on here, we need to describe the tax rules that limit the contributions and allocations made to a defined contribution plan. For those who are not familiar with the concept, a “defined contribution plan” is a retirement plan in which each participant’s benefit is equal to the amounts credited to the participant’s account under the plan. Under the terms of the plan, a participant can receive an allocation of employer contributions (and in many cases forfeitures) as well as earnings and losses on trust investments. For purposes of this article, we will discuss two retirement plan rules that limit the contributions and allocations under a defined contribution plan.
The Contribution Limit
The first rule, in Internal Revenue Code section 404, limits the amount of an employer’s contribution to a defined contribution plan. If the limit is exceeded, an excise tax will accrue on the excess contributions until they are removed or corrected. When we refer to the employer contribution, we are speaking of the total contribution the employer makes on behalf of all eligible participants for a particular plan year. Code section 404 limits the amount of the employer contribution that is deductible by the employer for a given plan year. In general, the deduction limit is 25 percent of eligible participants’ compensation in the case of profit sharing planning 401(k) plans, money purchase plans, or target benefit pension plans. A single 25 percent limit applies to all plans maintained by an employer.
In the case of participants who make more than $250,000 in 2008, only the first $250,000 may be treated as eligible compensation for retirement plan purposes, including the overall deduction limit. Therefore, the maximum deduction limit under the profit sharing plan of a small medical practice consisting of a doctor making $250,000 and a nurse making $75,000 would be 25 percent of $300,000, or $75,000.
The Allocation Limit
Apart from the overall deduction limit, there is a limit on the amount of the employer contribution (including forfeitures) that may be allocated to each participant’s account under a plan. This limit on the amount that may be allocated to each participant’s account under a defined contribution plan is sometimes referred to as the “annual addition limit” or the Code section 415(c) limit. Under this rule, for any given plan year, each participant may not receive allocations of more than 100 percent of the participant’s eligible compensation or $46,000, whichever is less, under all of the defined contribution plans of the same employer.
In case you didn’t notice, both of the limiting rules discussed apply to only the retirement plan or plans of the same employer. Therefore, whenever you have a new or separate employer for retirement plan purposes, you also have a new set of deduction and allocation limits. Let’s examine how these rules work in the context of various business transformations and transitions.
Transformation From Sole Proprietorship To Professional Corporation
Take, for example, the case of Dr. John Smith who has a successful specialty practice and expects to earn about $400,000 this year. Dr. Smith is practicing as a sole proprietorship. He has one common-law employee, Nurse Jones, who works full-time for him and makes $75,000 a year. Dr. Smith maintains a Keogh plan (i.e., a plan for self-employed individuals). Under this plan, he is able to contribute 25 percent of eligible compensation, a total of $75,000 allocate (more than percent but less than the annual addition limit).
For a variety of business reasons, including limitation of personal and business liability, he was advised by his attorney and CPA to incorporate his practice. Therefore, effective July 1, Dr. Smith sole proprietor became John Smith, M.D., Inc. As a result of the transformation, the retirement plan rules treat Dr. Smith’s sole proprietorship as one employer and his professional corporation as a separate employer, even though Dr. Smith and his nurse continue doing the same thing after June 30. Since Dr. Smith’s proprietorship does not continue to exist as an active trade or business after June 30 and does not co-exist with his professional corporation, the controlled group rules and affiliated service group rules that treat different employers as a single employer would not combine Dr. Smith’s proprietorship with his medical corporation for purposes of the deduction and allocation rules.
Voilà! Dr. Smith gets a fresh start in his new medical corporation for contribution and allocation purposes. Since we have assumed that Dr. Smith is capable of earning about $200,000 during the first six months of the year and another $200,000 during the second six months of the year, he is then in the enviable position of being able to establish a new retirement plan in his professional corporation during 2008 and fund the new retirement plan in addition to his Keogh plan for 2008. Assuming that his professional corporation adopts a retirement plan with a similar design, he can effectively contribute, deduct and receive an allocation for himself of $92,000 ($46,000 plus $46,000) under both plans for 2008. Of course, the nondiscrimination and coverage rules with respect to retirement plans may very well require Dr. Smith to cover Nurse Jones in the new plan as well. As a result, both are likely to receive an allocation under the proprietorship’s plan and the professional corporation’s plan. For those who can afford it, this opportunity to make a double contribution/allocation in one year may seem too good to be true. However, the IRS has issued a private letter ruling that appears to validate this technique.
Transition From One Practice To Another
As mentioned previously, this special ability to “double dip” is not limited to business transformations; it is also available to professionals and small-business owners who leave one employer to form or join another. Take, for example, the case of attorneys Adams, Bacon and Cobb. Because their intellectual property and computer law practice is thriving, they are able to maintain and fund a very generous 25 percent of compensation money purchase pension plan for all eligible employees. Furthermore, the plan states that a participant need only have 1,000 hours of service to be eligible.
Because of a serious disagreement involving the running of the firm, Adams decides to leave Adams, Bacon and Cobb and form his own firm in August 2008. Since Adams has already worked more than 1,000 hours during 2008, he is already entitled to an allocation for that year of the employer contribution under the Adams, Bacon and Cobb money purchase pension plan. However, since Adams will be able to establish a separate law corporation with a short tax year from August 2008 through December 2008, he will be able to establish a new retirement plan in his solo law corporation. If attorney Adams is able to net sufficient income during his short tax year, it is likely he can justify the establishment of a new retirement plan in his professional corporation and make a contribution and allocation for the short tax year. He will be able to receive allocations under both the Adams, Bacon and Cobb plan as well as the new Adams law firm plan.
Once again, the ability to establish, contribute to and receive an allocation under a separate retirement plan in the same year that an individual is receiving an allocation under another retirement plan depends upon whether the individual has sufficient eligible compensation from a new employer. Furthermore, the new employer must not be combined with the prior employer under the controlled group rules or affiliated service group rules.
Don’t Wait Too Long To Look Into This
To make a contribution to a qualified retirement plan for a given tax year, it is necessary to establish that plan quickly. Generally, this means that the retirement plan document must be completed and executed, and the corresponding trust funded, no later than the last day of the employer’s tax year for which the deduction is sought. Therefore, even though the retirement plan deduction rules allow an employer to fund its contribution for a given tax year up until the due date (including extensions) of the employer’s tax return (i.e., March 15 of the year following the end of a professional corporation’s December 31 fiscal year end), the qualified retirement plan of that professional corporation must be properly established no later than December 31. One exception to this rule applies to Simplified Employee Pension Plans, or SEPs, which can be established after the end of the employer’s tax year.
What To Do?
As you can see, there are some fairly interesting retirement plan opportunities that arise in the shuffle from one form of business to another or from one small business to another. Quite often the ability to establish a new retirement plan and receive an additional retirement allocation in the same year is overlooked. If your business is undergoing a transformation or transition of this sort, it may make sense to discuss the retirement plan implications with your accountant or employee-benefits attorney to see if you can take advantage of these rules.