Small businesses' considerations in Employee Benefits are varied, including factors not prevalent in large businesses. Factors include:
- Tax benefits in general (for all employees)
- Tax shelter and benefits for owners (to the exclusion, in many instances, of non-owners)
- Hiring and retention factors (benefits may attract and retain better employees)
- Insurance factors (health and death benefit protection)
- Creditor Protection Issues
Factor number 2 is less prevalent in “Big” businesses.
II. “Big” Plan vs. “Small” Plan Mentality
Counseling small businesses requires identifying the motivation of the owner(s). Benefits goals range from:
- "I want to be generous to employees.”
- "I want to match my competitor(s)' benefit plans but otherwise have no desire to benefit employees.”
- "I want to pay the employees fringe benefits of “X” amount and pay, if possible, “Y” (a much larger amount) to “myself.”
- "I want to give nothing, if possible to employees and keep all fringe benefits for myself.
Threshold of “Big” Plan mentality vs. “Small” Plan mentality varies but here is a chart we often use as guidepost:
Comment: It is a myth that a deduction saves taxes equal to the tax savings and that it is a wash to give the amount equal to tax savings to employees. Example – Pension Plan contribution of $20,000 at 28% federal bracket and 6% net state bracket. Savings? $6,800. Assume $6,800 goes to employees. $13,200 goes to owner. Owner later withdraws $13,200. Tax on it is $4,488. The cost is assumed to be $11,288. Owner ends up with $8,712 out of $20,000.
III. Entity Planning With Respect to Benefit Choices [PDF]
IV. Review of Qualified Plan Choices [PDF]
V. Equity Based Compensation For Small Business [PDF]
VI. Non Qualified Deferred Compensation
A. Traditional Deferred Compensation
Involves deferring or reserving income at the (normally C) corporate level and paying it later to employees (new strict Internal Revenue Code Section 409A means a formal nonqualified deferred compensation plan for owners is not feasible).
Income Tax Issues
Corporation does not deduct the deferral. NQDC use almost always limited to 15% corporate tax bracket (for non personal service corporations). Tax deduction at corporate level is when deferral is paid. IRC § 404(b).
Comment: Normally used by owners to shelter income at 15% federal corporate rate. Game plan is to keep funds at corporate level and pay funds later when owner is in lower bracket. Owners of small businesses normally do not use a formal deferred compensation plan or formal deferral of “declared” salary. Often they have informal severance pay (generally limited to 2 years' pay) contracts continuing salary for a time after retirement, or a formula defining deferred compensation to be paid upon termination.
IRS Regulations 31.3121(v) describes impact of Social Security Amendments Act of 1983. FICA implications are complex and a genuine consideration in NQDC. FICA normally applies when a “non-account” or “account” plan defines a legally binding ascertainable benefit to be paid at a future date. A full discussion of FICA implications is beyond the scope of this outline.
B. NonTraditional Informal NonQualified Deferred Compensation
Small C corporations often accumulate corporate retained earnings as an “informal” deferred compensation plan. This will be the only method that can be used for owners under the IRC § 409A rules.
Pros – 15% tax rate on first $50,000 of income for eligible C corporations. No current FICA implications. Possible deduction for compensation payout or other expense in later year. Possible eventual liquidation or corporation at capital gains rates. Possible gift of stock to children to shift gain to next generation. Death of owner (or spouse in community property context) step up basis up could allow tax free liquidation.
Cons – No assurance tax rate upon liquidation is favorable. If paid as compensation, resulting deduction may generate unusable net operating loss. Accumulated earnings tax (IRC § 532) implications for retained earnings over $250,000 ($150,000 for certain service corporations). Possible increased FICA in later year(s).
C. Rabbi Trust
(Not common in small businesses) – Assume the business establishes a deferred compensation plan for a non-owner – or a minority owner. He/she desires assurance the “funds will be there.” A Rabbi Trust is an irrevocable trust in which assets are set aside for the exclusive use of satisfying an employer's contractual obligation to pay deferred compensation. It can be funded in any manner including cash or insurance products. Rabbi Trusts are subject to the claims of general creditors but are inaccessible to the business for discretionary use until benefit obligations are met. The earliest IRS blessing of this was a private letter ruling involving deferred compensation provided by a congregation to its rabbi. Therefore, the term “Rabbi Trust.”
Comment: Rabbi Trusts are not typical with formal deferred compensation plans for owners. They are often funded with life insurance or “tax managed investments” to limit current taxable income to the corporation.
D. ERISA Implications
ERISA Sections 3 and 201 and their regulations describe exemptions from ERISA coverage.
CAUTION - Formal deferred compensation plans must be limited to select management employees or highly compensated employees (normally called “top hat” coverage) to avert ERISA coverage. Top hat plans are exempt from the participation, vesting, funding and fiduciary requirements of ERISA, but are subject to limited reporting and disclosure requirements. The business must file a brief one-time disclosure statement with the U.S. Department of Labor.
E. Split Dollar Insurance
Variations of Split Dollar abound. A traditional one used by the author (and the only one discussed here) is the collateral assignment approach as follows:
|Owners of Policy||Beneficiary of Policy|
|Employee||Spouse, children, Trust (ties into estate planning)|
Premium paid part by company and part by employee or owner – hence “split” dollar. Employee typically pays the “economic cost” of policy under P.S. 58 (or the lowest published and available term rate) and the company pays the rest. The company's payment is an advance, subject to return in accordance with the Split Dollar Agreement. A formal written collateral assignment is filed with the insurance company to secure the debt. The company can bonus the economic cost to the employee as taxable compensation.
Pros – Most of the premium is paid with 15% tax dollars (Split Dollar is not often used with S corporations or with C corporations not in the 15% federal bracket). Build up in value on funds is tax deferred within life insurance policy. Amount owed to the company now must bear interest under recent IRS regulations.
Cons – “Economic cost” continues until Split Dollar Agreement terminates.
S Corporation Issue: IRS PLR9651017 ruling indicates a collateral assignment split dollar life arrangement did not create a second class of stock to cause the corporation to lose its S corporation status (the IRS also ruled the particular arrangement did not cause the proceeds to be in the insureds' estates). Lack of the 15% corporation tax rate (and flow through owners) makes split dollar highly unusual in the S corporation context.
Reverse Split Dollar: A nontraditional split dollar arrangement known as “reverse split dollar” (noncharitable) rents death benefits to the corporation. Discussion of reverse split dollar is beyond the scope of this outline.
F. Corporate Owned Life Insurance
Life insurance schemes to deduct interest (at high interest rates) on corporate owned life insurance on employees lives (used at times in context of deferred compensation and some split dollar plans were attacked in the Health Reform Act of 1996. Interest is allowed only for policies on certain key employees and then only at specific rates (certain transitional rules apply). See IRC § 264(d).
VII. Fringe Benefit Plan
An overview of fringe benefit plans follows:
A. Group Health Insurance Plans
IRC §§ 104, 105 and 106 allow company paid tax free (for employees or C corporation owners) health insurance coverage and benefits for employees. Sole proprietors, partners and 2% shareholder-employees of S corporations have deduction limits under IRC § 162(1). Health Reform Act of 1996 added language to allow such benefits “through an arrangement having the effect of accident or health insurance” (i.e., certain large self-insured welfare plans, etc.). Long term care insurance (with dollar limits on premiums) was also added as a qualifying benefit in the 1996 Health Reform Act (IRC § 213(d)).
Pros – No anti-discrimination rules. Following repeal of 1986 Tax Reform Act IRC § 89, there is no requirement for coverage of non-owners (but watch the dividend issue).
Cons – Group insurance plans for employers of 20 or more employees (in prior calendar year) involve COBRA coverage (See IRC § 498B). This involves notices upon hire and upon termination of employment. Post employment termination coverage under a group health plan can be elected, at the employee's (or qualified beneficiary) expense (102% of the premium), for up to 18 months, 36 months for some qualifying events. Certain disabilities within the first 60 days of continuation coverage allow up to 11 months of coverage past the 18 months at 150% premium cost. California law extends COBRA-type coverage to employers with less than 20 employees.
Comment: COBRA, MSAs and Group Health Insurance are a full subject of their own. Work with your tax advisor and benefit consultant to get and stay in compliance! COBRA is fertile litigation ground.
B. Medical Diagnostic Reimbursement Plans
Not common. The “executive physical.” For employees only (no dependents). See IRS Reg § 1.105-11(g). A C corporation can provide tax free reimbursements of an employee's uninsured diagnostic expenses. There are no discrimination rules. A written plan or policy is normally necessary.
C. Medical Expense Reimbursement Plan
See IRC § 105(h). A business can offer tax free (see chart at beginning of outline on limits in non C corporations for owners) medical expense (treatment) reimbursements. A written plan is needed.
Pros – Allows uninsured expense coverage. Dependents can be covered.
Cons – 105(h) requires coverage of nondiscriminatory classification (3 years, age 25, non union), more than 25 hours per week and 7 months per year with possible use of the percentage classification test of IRC § 410(b). Benefits must be fixed dollar amounts – not a percentage of pay.
Example – C Corporation has 2 employee-owners and 6 other employees. 4 non-owner full-time employees have over 3 years of service (and meet all other requirements of age, etc.) as of beginning of plan years. 6 employees total. Plan must cover (under classification test of IRC (h)(3)(A)(ii)) 3 of the non-owner employees. One employee can be excluded in the document.
Comment: Assume the 3 employees use 50% of the benefits of the Plan. The Plan's “tax shelter” for owners is offset by the cost. Nontax employee benefit considerations then apply.
D. Cafeteria Plan (Section 125/Flexible Benefit Plan)
A Cafeteria Plan under IRC § 125 eliminates constructive receipt of income issues when an employee has choices between taxable and nontaxable benefits. Commonly involves salary reduction to purchase from a limited “menu” of “cafeteria” choices such as: (1) health insurance for dependents; (2) child care; (3) uninsured medical costs; (4) group life; (5) vacation days (less common as a benefit and only in employer funded plans); (6) possible 401(k) deferrals (only in employer funded plans). See Temp Reg § 1.125-2T. Long term care insurance may not be offered in a cafeteria plan. Nor may educational assistance under IRC § 127(b)(4) or deferred compensation under IRC § 125(d)(2).
Pros – Allows employees to convert after tax benefit choices to pre-tax. Employer and Employee save on FICA.
Cons – Discrimination tests apply. No more than 25% of tax free benefits may be used by key employees (IRC § 416(i)(1)). IRC § 125(g)(3) allows use of the Qualified Plan classification test under 410(b) and 3-year eligibility. Regulations require annual elections, for “use it or lose it” approach and, for noninsured medical benefits, “risk sharing” in which an employer could be liable for more than an employee's salary reductions. Child care plan tax benefits should be compared to child care tax credits.
Comment:Cafeteria Plans can occupy an entire seminar.
E. Dependent Care Assistance Plan – IRC § 129(d)
Usually part of a Cafeteria Plan. Rarely, in a small business, a stand-alone plan due to employee cost.
Pro – Tax free child care.
Con – Benefit is an added employer cost. No more than 25% of benefits may go to more that 5% owners. Plan must also meet discrimination tests of IRC § 129(d), i.e. average benefits to nonhighly compensated employees is 55% of benefits to HCEs (excluding employees under $25,000, age 21 and one year of service)
F. Group Term Life Insurance – IRC § 79
Up to $50,000 of term insurance death benefit coverage is tax free (for C corporation owners only).
Pro – Premiums not taxable to employee.
Con – Plan must meet discrimination tests of IRC § 79(d). Tax benefit of tax free premium offset by employee cost.
G. Wage Continuation (Disability Insurance) – IRC § 105
Employer written plan to pay disability insurance premiums for benefit of employee.
Pros – Disability premium is tax free (for C corporation owner-employees only). Potentially allows more insurance to be purchased with pre-tax dollars. No discrimination rules. Can be for owners only (subject to dividend issue).
Cons – Benefits from insurance, if disabled, are taxable. A business owner will have serious hindsight concern if he/she elects tax free premiums for 2 years, gets disabled, and receives taxable income.
Comment: Schemes to have employee pay, but employer reimburse at year end if no disability, have failed in court tests. Also see IRS Reg § 1.105-1(d)(2) in which a 3-year lookback applies on the source of premium payments unless there is a binding election between “pre-tax” or “after-tax” prior to the beginning of the year.
Voluntary Employees Beneficiary Associations under IRC § 501©(9) are rare in small businesses. Tax Reform Act of 1984 added IRC §§ 419 and 419A to severely limit deductions. Exception in § 419A for “over 10 employer plans” is exploited (in author's opinion) in a number of tax shelter motivated severance pay etc. plans that often involve significant tax or economic risk. A 1997 Tax Court decision explains requirements for qualifying for the “over 10 employer plan” exception. A discussion of the implications is beyond the scope of this outline.
Pros – Possible tax deductions, if plan is properly structured. Possible use of Federal rules (other than California) relating to accrual of vacation pay in properly funded vacation pay VEBA.
Cons – Possible economic risk of loss if plan is properly structured to not involve “experience rating.” Possible IRS attack on plan deductions. Employee cost if plan properly meets discrimination tests of IRC § 501©(9).
Comment I: There are a number of VEBA “deals” around – some of which involve tax exempt VEBAs and other involve taxable trusts (VEBA that do not qualify for tax exempt status). Be very cautious and see competent counsel before advising a company to sign up on a VEBA. Some proposals are overly insurance oriented and economically costly even if the tax deduction treatment is not challenged by the IRS.
Comment II: VEBAs can be useful for small business contractors who do government contracting and need a “Davis-Bacon” qualified welfare plan to deposit vacation and health insurance benefits mandated under David-Bacon contracts.
I. Comment on Multiple Entities
A series of rules under IRC §§ 414 and 1563 aggregate entities for coverage. Congress has attempted to plug numerous perceived loopholes exploited by taxpayers in entity structure who attempted to avoid covering employees. No discussion of employee benefits is complete without reference to the following tests:
A. Controlled Group of Corporations: IRC § 414(b) refers to IRC § 1563(a) to treat all members of a controlled group of corporations as treated as employed by a single employer for IRC §§ 125, 401, 408(k), 410, 411, 415, and 416. The tests of Section 1563(a) are beyond the scope of this outline but the principal threshold is the “80% common ownership test,” and a companion 50% identical ownership test.
Example: A and B equally own Company X. A also owns 90% of company Y. B owns none of Y. X and Y are not in a controlled group (unless ownership options, family attribution rules, “substance over form” or some other aggregation rule applies).
B. Businesses Under Common Control - IRC § 414©: Unincorporated and incorporated businesses are also aggregated under IRC § 414© under rules similar to Section 1563(a). See Reg § 1.414©-1, et al.
C. Affiliated Service Groups - IRC § 414(m): IRC § 414(m) was added in 1980 to plug the loophole under which corporations in service businesses (see IRC § 414(m)(3)) were creating partnerships of corporations – and the IRS was losing challenges it based on a 1968 Revenue Ruling claiming the partnership's non-owner employees were aggregated for benefit purposes with the owner-employees if the corporations.
Example: 4 lawyers each incorporate separate corporations and form a partnership of corporations. IRC § 414(b) and © does not aggregate them. IRC § 414(m) treats all entities as one group for benefit plan purposes.
D. Affiliated Management Businesses – IRC § 414(m)(5): A new form of loophole emerged after enactment of IRC § 414(m) – the incorporated executive. Executives with insufficient ownership percentages for aggregation under § 414(b) or © formed management entities to contract with the businesses they managed. IRC § 414(m)(5) was added, beginning in 1984. It aggregates an entity performing management functions for another entity on a regular basis (the “principal business” test) for benefit purposes.
Comment I: The interpretation of IRC § 414(m)(5) is in doubt due to the IRS withdrawal of Reg. § 1.414(m)(5) on April 27, 1993. The proposed regulations were viewed to be overly expansive in defining “management” to include professional services whether they were management in nature. The IRS was concerned about the incorporated (or not) independent contractor doctor-lawyer, etc. to a group he/she owns none of being able to have his/her own pension/benefit plan.
Comment II: Withdrawal of the proposed regulations does not mean IRC § 414(m)(5) is dead. Managers who incorporate (a corporation is not required to invoke § 414(m)(5)) and “attach” themselves to one company will likely fall within § 414(m)(5). Another line of attack used by the IRS in both management and nonmanagement situations is to claim the executive is a common law employee of the business that he/she provides service to. This blows up the entire agreement, with significant tax/employee benefit issues for both sides. Reclassification of independent contractors as common law employees creates a ripple effect on FICA, benefit coverage and other issues. Benefit plans set up by the contractors, if any, also face disqualification (as they would be treated as employees rather than self-employed businesspersons).
E. Independent Contractor vs. Employee Issues: Proper classification of employees and independent contractors who are later reclassified can be vital to qualification of benefit plans, as well as to reduce exposure from independent contractors (or the IRS/Franchise Tax Board) claiming as employees, they should have been covered under Pension Plans, group insurance plans, workers compensation plans, etc. A full discussion of independent contractor vs. employee issues is beyond the scope of the program.
F. Leased Employees – IRC § 414(n): Employees of a “leasing company” who provide services to a recipient company are aggregated for virtually all benefit plan purposes. IRC § 414(n). A “safe harbor” to exempt coverage is very limited in scope and applies only if leased employees are less than 20% of the nonhighly compensated workforce, and a 10% fully vested immediate eligibility money purchase plan is maintained by the leasing company.
Comment: The Small Business Job Protection Act of 1996 amended Section 414(n) to change the applicable test to a “primary direction and control by the recipient test.” The change is designed to make aggregation easier, especially in circumstances where the prior “historically performed” test made longstanding employee leasing arrangements difficult to attack (particularly in some health organizations).
VIII. Small Business Job Protection Act of 1996 And 1997 Tax Reform Selected Issues
A. Comments on SIMPLE Plans or IRAs:
The outline previously referred to SIMPLE/IRAs.
Query: Which type of company will use SIMPLE?
- 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.
- Will 100% vested contributions to SIMPLE really be less costly than a 6- or 7-year vesting schedule on traditional 401(k) contributions?
- 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?
- Always consider creditor protection issues when choosing between SIMPLE IRA vs. SIMPLE 401(k).
B. S Corporations with ESOPs?
Internal Revenue Code Section 1361©(7)(A) allows an ESOP to own stock in an S corporation. Good news?
Basics of rule:
- Plan counts as one shareholder for 75 shareholder rule.
- 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
- 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.
- 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.
- 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.
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) – 19.56% NHCE Ratio 25% x 70% = 17.5%||25% HCE ratio|
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.