AICPA Case Study

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King and Nordlinger, L.L.P.
Washington, DC

Facts: Infinity Design, Inc. (IDI) is a closely held corporation involved in engineering design work. IDI's stock is equally owned by James Jackson and Joe Johnson, both registered professional engineers. In addition to the two stockholders, the company employs 12 other engineers, five technicians and two administrative employees. The corporation projects gross receipts of $2.5 million and a net profit of $200,000 for the current year. The company has a stable workforce and all current employees have been working for IDI for over one year. James and Joe would like to establish a retirement plan for the corporation's employees as a way of deferring taxability of some of their own current income and to provide an incentive for the other employees to remain with the company. Most of the employees have also expressed a desire to be able to defer some of their current taxable income to later years. However, James and Joe are concerned about the cost of such a plan, and about the ability of the company to continue to make contributions in future years. Issue: What type of retirement plan can IDI adopt that will meet the company's objectives?

There are many types of retirement plans available. For various reasons, James and Joe are not enthusiastic about the normal corporate defined benefit or defined contribution plans. They are intrigued by the administrative ease of a savings incentive match plan for employees (SIMPLE) plan, but would like to be able to defer more than $6,000 per year of their salaries. A simplified employee pension (SEP) plan is also a possibility, but it does not provide deferral for employees and does little to bind them to the corporation (as they are immediately 100% vested in their accounts).

After discussing the various alternatives, James and Joe decide they would like to adopt a qualified cash or deferred arrangement, also known as a Sec. 401(k) plan, for the following reasons:

1. This plan provides a method for each employee to defer a portion of his own salary, as well as have the company provide additional funds for retirement.

2. The plan can have a vesting schedule for the employer portion of the contributions. This will provide an incentive for employees to remain with the company to receive their full benefits.

3. The plan can establish participation standards that will at least exclude probationary (new) employees.

4. In addition to the employer's matching contributions, the plan can contain a profit-sharing feature that can be funded on a discretionary basis from year to year as profits are available.

5. Although there is a requirement to file an annual return for the plan and perform end-of-year testing to ensure it meets nondiscrimination requirements, there are many companies available to perform these services for a relatively minor cost to the company.

The tax adviser advises James and Joe to contact a company that specializes in setting up and administering retirement plans. After meeting with several representatives, they select Kimble Funds to set up and administer the plan. Kimble will set up the plan for a one-time cost of $2,500 and charge an annual fee of $1,200 to perform all necessary testing and file the annual return. Kimble assists IDI in establishing the following plan, which will be effective on January 1 of next year:

1. Each eligible employee will have the option to defer up to 15% of salary, subject to the annual limitation provided in Sec. 402(g). (For 1999, this limitation is $10,000.) This arrangement provides the "cash or deferred" element of the plan; the employee can choose to continue to receive that portion of his salary in cash or defer it into the retirement plan. A salary deferral will not be included in the employee's taxable income for the year the elective contribution is made. However, the deferred amounts remain subject to both FICA and FUTA taxes for the year the salary is paid. Each employee will immediately be 100% vested in these elective deferrals.

2. IDI will match the employee's contribution at the rate of one-half of each dollar contributed, up to 8% of the employee's salary. Therefore, the maximum that IDI will contribute will be 4% of each participating employee's salary. It also limits the company's cash requirements to a set amount for each year, which can be appropriately budgeted.

3. Any employee over the age of 21, with at least one year of service, will be able to participate in the plan. The current employees will be given credit for past service, meaning that all current employees will be able to participate if they so choose. These provisions meet the participation standards of Sec. 410(a)(1).

The plan will have a vesting schedule for the employer portion of plan contrutions. The plan adopts a six-year graded schedule, which provides vesting as follows:

Years of Service

Vesting Percentage

20%

40%

60%

80%

100%

Once again, for this purpose current employees will be given credit for their past years of service in determining their vesting percentage. This vesting schedule satisfies the requirements of Sec. 411(a)(2), as well as Sec. 416(b) (which pertains to top-heavy plans).

5. The plan will allow the company to make a profit-sharing contribution equal to no more than 5% of the employee's annual compensation. This profit-sharing contribution will be totally at the company's discretion from year to year. It should be noted that, under Sec. 415(c), the entire amount contributed to an employee's account for any year cannot exceed the lesser of $30,000 or 25% of total compensation.

6. The plan sets the normal retirement date at age 65. It also establishes an early retirement date of age 60 with at least 10 years of service. The employees will not be allowed to take distributions from the plan except on retirement, death, disability, separation from service, certain hardships or termination and distribution of plan assets. This provision satisfies the requirements of Sec. 401(k)(2)(B).

This Sec. 401(k) plan meets IDI's goals of deferral of employees' current income, profit-sharing and employee retention.

It should be noted that there are many complex nondiscrimination requirements that the plan must continue to meet on an annual basis; these requirements become even more onerous if the plan is determined to be top-heavy. If the company does not have someone on staff capable of meeting the necessary testing and filing requirements, it is imperative that competent outside assistance be obtained to perform these duties. The penalties for noncompliance can be severe.

There are many companies able to provide the entire spectrum of services required for Sec. 401(k) plans. This would include providing various investment choices for the employee funds, as well as the other plan administrative requirements. In most cases, the cost of obtaining these services is far less than the risk of exposure for noncompliance with applicable requirements.

Editor's note: This case study has been adapted from "PPC Tax Planning Guide—S Corporations," 12th Edition, by Andrew R. Biebl and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, Tex., 1998.