Defined benefits may take the sting out of tax time

Tax time. The only time of the year when being a profitable business can be unpleasant. No one likes to write a big check to the government, and everyone wants a magic pill that will eliminate or reduce the amount of taxes paid.

In my tax practice, I am often asked how to reduce taxes. Generally, this happens after I deliver the bad news to a client. They know that somewhere in the ether are tax ideas that if used properly, can eliminate all of their tax liability.

There really aren't that many magic pills out there. The tax code is continually modified to snuff out the magic, and as soon as a loophole surfaces, new law is enacted. The tax code did not grow to more than 74,000 pages by accident.

Retirement savings are a good way to defer the taxation of earnings, but generally, the amount allowed to be deferred from current taxation is limited. There is still one way to put away a substantial amount for retirement and reduce current tax liability — a defined benefit plan.

Defined benefit plans were once the staple of large businesses but have now fallen out of vogue because of the high cost of funding. For small businesses, under the right circumstances, they may make a lot of sense.

Defined benefit plans provide employees with a set monthly benefit in retirement. These plans can work like magic for successful business with the right set of circumstances. An older business owner could possibly defer up to $210,000 of income into a retirement account for his own benefit. Earnings inside this account will accumulate tax free until distributions are taken.

These plans work for businesses that have a small number of employees consisting of an older owner and young employees. Because the plan will be funded to provide a set benefit in retirement, the contribution for the owner will be much larger than the younger employees because the owner has less time to retirement age. The plan will also provide a benefit based upon current salary levels, so if the owner makes substantially more than the employees, the amount funded into the owner's account will be proportionately larger.

Now for an example. Dr. X is a successful cardiologist who adopted a defined benefit plan. She is in her mid-50s and has five employees in her practice. All of her employees are in their 20s and 30s, and Dr. X has a substantially larger salary than any of her employees. An actuary will determine, on a yearly basis, the amount needed to fund the plan to provide a set monthly retirement benefit for all of the eligible employees. For our example, the actuary determines that of this amount, approximately 98% will be allocated to Dr. X's benefit and the remaining 2% will be allocated to the other employees of the practice.

Dr. X has taxable income from her medical practice before the pension deduction of $750,000. For example purposes, the total pension contribution is $200,000 and she is in the top tax bracket. She can reduce her income down to $550,000, saving $79,200 in current income taxes.

These plans work for small businesses that have stable profitability and older owners who desire to build retirement savings. It could be a good fit for the entrepreneur who neglected saving for retirement in the past but now finds himself with excess cash in their business.

The plans do have a couple of downsides. First, they are not cheap to implement or maintain. They must be drafted by professionals and an actuarial computation must be performed on a yearly basis. Also, to be compliant with IRS rules, the plan has to be funded for at least five years. The thought of a mandatory six-figure expense for a five-year period can be daunting, especially if the business is subject to market swings. If a business has a down year, the owner has to be ready to contribute money to the business so it can fund the retirement plan.

After the plan has been funded for five years, and the business does not want to continue making the annual contributions, the plan can be dissolved with account balances rolled into individual IRA accounts.

If you feel like your business is a candidate for a defined benefit plan, contact a professional who specializes in this area. He or she can run the numbers and tell you if it works for your circumstances.

Advantages
Allow small businesses to defer substantial income and avoid current taxation
Older owners can accumulate large retirement fund balances

Disadvantages
Must fund to a minimum level for five years
Implementation and administration can be costly

Pamela Schuneman,  C.P.A., is a practicing tax accountant in Sarasota. She has 33 years of experience helping her clients navigate the vast federal tax system and has worked with businesses as varied as Fortune 500 companies to small sole-proprietors. Contact her at [email protected]