I. Small Business Job Protection Act of 1996 And 1997 Tax Reform –
Selected Issues

In this section

  1. Comments on SIMPLE Plans or IRAs

  2. S Corporations with ESOPs?

  3. Defined Contribution Plans Coverage Testing

A.                 Comments on SIMPLE Plans or IRAs:

The outline previously referred to SIMPLE/IRAs.

Query: Which type of company will use SIMPLE?

Observations:

  1. How often will the cost of the SIMPLE mandatory contribution be more than the tax savings of the owner(s) own deferral (and contribution)?  Small company’s owners may benefit, but those with over 4-10 eligible employees are not likely to.
     

  2. Will 100% vested contributions to SIMPLE really be less costly than a 6- or 7-year vesting schedule on traditional 401(k) contributions?
     

  3. Is $10,000 contribution level for owners worth it – when IRA rules potentially will allow owner and spouse to put $4,000 each to IRAs?
     

  4. Always consider creditor protection issues when choosing between SIMPLE IRA vs. SIMPLE 401(k).

back to top

B.                 S Corporations with ESOPs?

Internal Revenue Code Section 1361(c)(7)(A) allows an ESOP to own stock in an S corporation.  Good news?

Basics of rule:

  1. Plan counts as one shareholder for 75 shareholder rule.
     

  2. Income on K-1 to an ESOP Plan is NOT UBTI, but the Internal Revenue Code has significant penalties for small ESOPs benefiting key owners.  An excise tax and income pass through applies.

Special ESOP Rules

1.         IRC Section 404(a)(9)’s increased ESOP deduction limits do not apply to S corporation.  Dividends are nondeductible too – no big surprise as an S corporation is basically a “pass-thru” tax entity anyway.

2.         IRC Section 1042 tax free rollover treatment does not apply to sales of S corporation stock to an ESOP.  Question – Can you sell C corporation shares under 1042 and later convert to an S corporation without affecting the sale rollover? Seems so.

3.         A rollover by a participant of ESOP employer securities to an IRA causes disqualification of S corporation status.  IRC § 409 has provisions designed to help avert this.

Comment II:    No pension advisor should counsel a C corporation to convert to an S corporation or vice versa for some perceived pension reason without involving tax advisors to consider the overall pros and cons of the S vs. C choice.  There are significant pension and nonpension tax issues to consider.

back to top

C.                Defined Contribution Plans Coverage Testing

Plan coverage under DC Plan is limited to tests of §§ 410(a) and 410(b)!  Example:

ABC Company has 50 employees who meet 1-year – age 21, etc. requirement.  4 are HCEs.  46 NHCEs.  ABC Company desires a Plan covering 10 people.  1 HCE and 9 NHCEs.

Plan meets 410(b) –             25% HCE ratio
19.56% NHCE Ratio
25% x 70% = 17.5%

Comment I:    410(a) and 410(b) are the major tests.  “Grouping” combinations of HCEs and NHCEs in separate distinct plans is feasible.

Comment II:    Minor change to Defined Benefit IRC 401(a)(26)

Joe Blow, M.D. and John Smith, M.D. Inc. have a DB Plan and Money Purchase Plan.  Joe Blow, M.D. is in DB.  John Smith, M.D. has a Money Purchase Plan.  Both are HCEs             (assume no NHCEs meet 2-year eligibility standard).

                        401(a)(26) Test NOT okay.

                        DB Plan needs at least 2 people to qualify.

back to top