How An Employee Perk Can Be A Tax Advantage

One small company owner, with a preference for profit-sharing, ended up with a pension plan instead.

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It is no secret that qualified retirement plans remain one of the last great tax shelters available to small businesses. The federal government has encouraged the installation of such plans through favorable tax legislation since 1954. With that encouragement, however, has come seemingly endless revisions in the regulations, ranging from the Employee Retirement Income Security Act of 1974 (ERISA) to new restrictions in the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). For small business owners, the result is a staggering maze of alternatives and requirements.

If you own an incorporated business and are concerned about instituting a retirement plan, begin by considering these questions:

1. Is your business profitable?

2. Are you, as the owner, earning enough to satisfy your needs and those of your family?

3. Are you currently making full use of other corporate tax advantages?

4. Are you willing to provide additional benefits to some -- if not all -- of your employees?

If you answer yes to those four questions, you should consider setting up a qualified retirement plan for your company. The plan may be one of two types, either a pension plan or a profit-sharing plan. At the outset, however, to deal with the tax considerations, avoid deciding which plan might be more appropriate. You can have more than one plan. Concentrate first on the tax benefits that a retirement plan will create for your company and its employees.

A qualified plan can produce three chief tax advantages. First, employer contributions to the plan are fully tax-deductible as a business expense. Income before taxes, therefore, is reduced. Second, employees pay no tax on the amounts contributed to thc plan until actual receipt of the benefits. And third, not only are the contributions made with tax-deductible dollars, but the earnings on these contributions accumulate on a tax-deferred basis throughout the years. This tax-sheltered growth over 10, 20, or 30 years allows the buildup of a substantial retirement fund for business owners and employees alike.

To illustrate how one small business owner came to terms with retirement planning, consider the case of Jerry Bishop (not his real name), who founded his own machine-tool manufacturing company in 1976. Starting out with four employees, including Bishop himself, the business prospered and expanded. By 1981, at the age of 44, Bishop had 15 employees, including his wife, Eileen. He owned the plant and was confident the business would continue to grow.

Last year, another business owner suggested that Bishop establish a profit-sharing plan, since it would involve "no fixed commitment" on the part of the corporation. At that point, Bishop was projecting an increase in 1982 profits of $26,000. Based on the company's 46% tax bracket, these increased profits could generate $11,960 ($26,000 X 0.46) in additional taxes. To reduce the company's increasing tax burden, Bishop's accountant suggested he set up a qualified retirement plan with a $26,000 contribution. In this way, the company could shelter the gain, boost employee benefits, and save nearly $12,000 in taxes.

Working with a consultant, Bishop was persuaded to compare pension and profit-sharing plan alternatives based on an analysis of his employees, their ages, years of service, and compensation (see Table I). Besides aiming for a plan that would require a company contribution of $26,000,

Bishop also wanted to ensure that a select group of his four original employees -- including himself and his wife -- would share the bulk of that contribution.

TABLE I

Employee Age Years of service Compensation

Bishop 45 5 $40,000

Eileen 44 5 $13,000

2 key employees 42 (avg.) 5 $24,000 (avg.)

6 other employees 30 (avg.) 3 $18,000 (avg.)

5 remaining employees 25 (avg.) 1.5 $12,000 (avg.)

The consultant proposed three options, showing contributions for each group of employees ranging from 0 to 82% (see Table II). The options were weighted heavily toward the four veteran employees, with some reward for six others, and no participation for the younger, newer staff members. The proposals met Bishop's objectives, but he still had to choose the most appropriate option.

TABLE II*4*$26,000 contribution alternatives

(% of contribution for each group of employees)

Defined benefit Target benefit Profit-

Employee group pension plan pension plan sharing plan

Bishop, Eileen,

and 2 key employees 82% 75% 51%

6 other employees 18% 25% 49%

5 remaining employees 0% 0% 0%

Under Jerry Bishop's plan, five employees were eliminated from participation because of their age and limited years of service. Six other employees had their contributions reduced by integration with Social Security. This left a select group -- Bishop, Eileen, and the two key employees -- to utilize the bulk of the company's contribution to the new pension plan.

Because of his company's tax bracket, Bishop knew that the tax savings, regardless of the plan he chose, would be 46%. In effect, the real cost of any plan would be 54% of the contribution (100% -- 46%). The big question was, which plan, in terms of real cost, would benefit the select group most? To answer that, Bishop compared the benefit of each plan to the select group as a percent of real cost. Under the profit-sharing plan, the benefit would be 94% (51% divided by 54%), compared with 139% for the target benefit plan (75% divided by 54%) and 152% for the defined benefitplan (82% divided by 54%).

Bishop felt strongly that those who had contributed most to the company's success -- the select group -- should benefit most. The pension plan options allowed this. He thus eliminated further consideration of the profit-sharing plan.

Although the remaining pension plan options were attractive, Bishop was bothered by a very common objection to pension plans in general: their perceived inflexibility and long-term fixed-dollar commitment. After studying the two plans, however, he realized his concerns were unjustified. In simple terms, this is how Bishop assessed the two plans.

Defined benefit pension plan. Under such a plan, retirement benefits would be defined in advance by applying a formula to compensation. The plan would commit to pay -- and would have to fund -- a specific stated benefit at retirement age. Company contributions to fund the benefit would be determined actuarially. Because it would require actuarial services, it would be the most costly plan to set up and administer. As a further complication, an annual report on such a plan must be filed with the Pension Benefit Guaranty Corp. (PBGC) as well as the Internal Revenue Service. Furthermore, to terminate company contributions in most cases would require PBGC and IRS approval and could take a year to accomplish. While defined benefit pension plans can be attractive, there should be little doubt as to a corporation's ability to make maximum contributions in the foreseeable future, that is, at least for the next five years. Target benefit pension plan. Generally accepted as a hybrid, a target plan would offer the design capabilities of a defined benefit plan but would be less complicated. Under such a plan, which does not require an actuary, the company contribution would be established at a level targeted to enable the plan to pay a defined benefit at retirement. Reduction or termination of plan contributions could be accomplished at any anniversary without PBGC or IRS approval. Unlike the defined benefit plan, the target benefit plan allows necessary changes to be made annually. If, for example, Bishop's company experienced a setback in 1983 profitability, its commitment to the plan could be adjusted easily at year-end.

Weighing the two pension plans, Bishop and his advisers agreed that, for his company, the target benefit pension was the best option. He thus instituted the target plan cited in Table II. While it was set up before TEFRA, the plan satisfies the latest regulations imposed by the 1982 tax act. By design, it is a "top heavy" plan; that is, it discriminates in favor of a select group of employees. But, as Bishop points out, the plan provides far more than the 3% minimum contribution to non-key employees stipulated by TEFRA. He also notes that it is only the first step in instituting company retirement benefits. It will meet his tax-saving objectives this year, but it does not preclude additional benefits or the addition of a companywide profit-sharing plan in the future.

The company's experience offers two lessons in retirement benefits. First, there is no standard blueprint. Establishment of any qualified plan depends on each company's employee makeup and corporate objectives. Second, few, if any, small companies should attempt to set up a plan without professional assistance. Ask your accountant, attorney, and banker for references to professionals who specialize in pension and profit-sharing plans. Look for someone with a good reputation in this area as well as the requisite expertise. Once a plan is designed and implemented, annual services must be provided, including individual employee benefit records, summary reviews, and filing of required reports with the government. The cost of a professional's services is incidental when compared with the benefits to be derived from a well-designed plan that is properly serviced from year to year.