The current pension legislation was just given a boost to assist business owners of closely held privately entities with income tax planning strategies to help manage current income taxes as well as attract, retain, and reward talent to their businesses.

President Trump signed the Tax Cuts and Jobs Act (TCJA) into law in December 2017. The TCJA added the qualified business income deduction, which is a tax deduction for business owners of pass-through entities. Generally, this new deduction allows business owners of pass-through entities to take a deduction of up to 20% of their pass-through profits. However, there are taxable income thresholds that phase out this deduction, so maximizing a business owner’s tax deductions may be important to qualify for this new 20% deduction. Qualified retirement plans can provide a business owner with tax deductions for plan contributions, as well as reduce the business owner’s taxable income below the thresholds to qualify for the 20% deduction, providing a double benefit of a qualified plan.

The IRC 199A Qualified Business Income Deduction

While this new deduction is quite complex, here are some simplified rules to help understand how it works. If a pass-through business owner has taxable income below the threshold ($315,000 for married filing joint and $157,500 for single filers), he/she can generally take a 20% deduction of his/her pass-through income. For example, if Dave files jointly with his spouse and has $100,000 of income from his sole proprietorship and their total combined taxable income is $150,000, he can take a $20,000 deduction (20% × $100,000), so that his taxable income would be $130,000.

There are phase-outs of the deduction when taxable income is between $315,000 and $415,000 for married filing joint taxpayers and between $157,500 and $207,500 for single taxpayers. But, the important thing to remember here is that once taxable income reaches the $415,000/$207,500 level, there are a new set of rules to follow when calculating the deduction. If a business is a non-service business, then the deduction is generally limited to the greater of (1) 50% of W-2 wages paid to employees or (2) 25% of W-2 wages paid to employees plus 2.5% of the unadjusted basis of certain property in the business.

However, for a specified service business, once a taxpayer’s taxable income reaches the $415,000/$207,500 mark, there is no deduction at all. A specified service business is any business that has income from the following activities: health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, any business where the principal asset is the reputation or skill of one or more employees, or any business which involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities. As you can see, this captures a lot of professionals.

Therefore, managing the taxable income of owners of specified services businesses is critical in being able to claim the new 20% qualified business income deduction. And a qualified retirement plan may be a great way to do that.

Higher Funding Limits:

• The employer deduction limit for individual allocations applicable to profit-sharing plans is $56,000 (as indexed for 2019) or $62,000 for individuals over age 50, inclusive to 401(k) catch-up deferrals; the annual deductible contribution limit is 25% of participation payroll.
• The maximum annual 401(k) deferral limit for individuals is $19,000 (as indexed for 2019).
• Plan participants who are older than 50 are eligible for catch-up contributions up to $6,000 (as indexed for 2019) if the plan permits 401(k) deferrals.
• The maximum compensation limit used to calculate contributions or benefits for defined contribution plans and defined benefit plans is $280,000 (as indexed for 2019).
• The defined benefit maximum limit is $225,000 (as indexed for 2019) for benefit payment based on a single-life annuity with a retirement age of 62. This limit may be reduced if the participant has less than 10 years of participation.

Furthermore, 401(k) deferrals do not count towards the 25% annual addition limits. This can lower the profit-sharing formula and reduce the employee cost to owners.

Contributions to Owners and Key Employees

An effective design commonly used for allocating a larger percentage of contribution to owners and key employees in a profit-sharing plan is the “new comparability” or “cross-testing” allocation formula. Depending upon the demographics of the business, the results might exceed those of plans using a permitted disparity design (also known as Social Security integration). Since the passage of PPA and the relaxation of IRC section 404(a)(7), companies are allowed to fully fund both a defined benefit plan and a profit-sharing plan if the business is subject to Pension Benefit Guaranty Corporation (PBGC) premiums.

Companies not subject to PBGC premiums are owner-only and owner-and-spouse companies that have no other employees, as well as professional services corporations that have fewer than 25 employees.

These companies are allowed to have both a defined benefit plan and a profit-sharing plan with 401(k) deferral, but the employer’s profit-sharing contribution is limited to 6% of participation payroll. By funding both a profit-sharing and defined benefit plan, business owners have the ability to make larger tax-deductible contributions. Actuaries now also have a larger landscape in which to allocate employee costs, often resulting in a more efficient allocation of overall employee cost. Coverage rules under IRC sections 410(b) and 401(a)(26) must still be factored into the plan design.

Renewed Popularity of Defined Benefit Plans

In the past, plan sponsors might have been hesitant to convert an existing traditional defined benefit plan into a cash-balance plan because many courts had ruled that these plans were discriminatory on the basis of age; however, PPA provides legal certainty for employers and plan sponsors that establish a cash-balance pension plan by clarifying that such plans do not violate discrimination laws if certain conditions are met. Court approval of IBM’S conversion of its traditional defined benefit plan to a cash-balance defined benefit plan helped set this precedent in Cooper v. IBM Personal Pension Plan. Unlike a traditional defined benefit plan, in which benefits are expressed as a monthly benefit payable at retirement, cash-balance plans show benefits as a hypothetical individual account balance, similar to a profit-sharing or 401(k) plan. A benefit expressed in this fashion is easier for most employees to understand.

Another profound change in PPA is the ability to fund up to 150% of a funding target, minus current assets. While this provision helps an underfunded plan’s asset value catch up to the plan’s accrued liabilities, it can help a new plan as well. Historically, defined benefit plans have been known for inflexible contribution requirements. Actuaries can now provide a range of contributions indicated by minimum and maximum funding amounts, providing greater flexibility for future contributions.

Creative Planning Opportunities for Your Clients

Additional planning opportunities to structure a qualified plan can include:

• Income received from board member fees
• Income received from royalties, publishing, consulting, and management fees
• A single year contribution in a year with a large windfall of earned income
• Larger size entities with multiple locations
• A mechanism for a buy out of a current owner by the current key personnel team

Multiple Planning Purposes Using Life Insurance             

In addition to creating a retirement nest egg, profit-sharing and defined benefit plans can accomplish other business and personal planning objectives, including buy-sell arrangements, succession planning, and deferred compensation benefits, as well as distribution and estate planning. They provide an available income of capital to fund life insurance premiums that otherwise might not be available for personal cash flow reasons. The leverage gained from the use of tax-deductible dollars makes plan assets a funding source for life insurance. With proper planning, the purchase of life insurance can provide substantial benefits to a plan participant and can meet personal and business planning needs.

A primary concern when purchasing life insurance with qualified plan funds is removing the policy from the plan at some future date. This would occur if the insured participant retired or terminated employment, or if the plan terminated. Distribution and purchase from the plan represent two methods of removing a policy from the plan. For a more in-depth discussion of options, see Kenneth A. Horowitz’s “Exit Strategies for Life Insurance Policies in Qualified Plans,” found here.

 In all cases, the availability of life insurance at a significantly lower cost while in the plan, plus the benefits of portability at retirement or plan termination, will usually offset the cost required to remove the insurance from the plan.

Overview of Benefits and Takeaways

Under the current income tax and pension legislation, there are a multitude of benefits are available to business owners engaged in profit-sharing and defined benefit plans, including the following:

• Benefits range from more efficient, lower employee-cost plan designs, to maximizing owner contributions. Overall, annual contribution limits have been increased to the mid-six figures for individuals. The company also gets to deduct contributions made on behalf of all of the employees.
• Typically, percentages can range from 80% to 90% for owner and key employees. Therefore, employee costs are typically funded from tax savings.
• Plan document preparation and annual administration expenses have been lowered to a range of $1,500 to $2,500. A credit of $500 is also available for the first three years of newly sponsored plans.
• Qualified plans can be a viable planning tool in order to save money on a tax-deductible basis.
• An efficient way to Recruit, Retain & Reward talent to a company.

Other business and personal planning needs can be accomplished inside a pension or profit-sharing plan, such as funding buy-sell arrangements, deferring compensation, facilitating succession and estate planning, and meeting life insurance needs

Kenneth A. Horowitz is a Registered Representative and Financial Advisor of Park Avenue Securities, LLC (PAS), 914-288-8800. Securities products/services and advisory services are offered through PAS, a registered broker/dealer and investment advisor, Field Representative of the Guardian Life Insurance Company of America (Guardian), New York, N.Y.  PAS is an indirect, wholly owned subsidiary of Guardian. Associated Benefit Consultants, LLC is not an affiliate of PAS or Guardian. PAS is a member of FINRA, SIPC. Guardian, its subsidiaries, agents and employees do not provide tax, legal, or accounting advice. Consult your tax, legal, or accounting professional regarding your individual situation. 2019-82950 Exp. 7/21