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Establishing a
Defined-Benefit Plan Editor: Editor’s note: This case study has been adapted from PPCs Tax Planning GuideClosely Held Corporations, 17th Edition, by Albert L. Grasso, Joan Wilson Gray, R. Barry Johnson, Lewis A. Siegel, Richard L. Burris, James A. Keller, Gary W. Brown, James J. Mogelnicki and William R. Bischoff, published by Practitioners Publishing Company, Fort Worth, TX, 2004 ((800) 323-8724; www.ppcnet.com ). A defined-benefit (DB) pension plan is designed to provide a definitely determinable annual retirement benefit in the form of a pension. The benefit is calculated using the plans benefit formula and must be funded during the employees working years. The computation of the annual contribution needed to provide this benefit requires complex actuarial calculations. This annual contribution becomes a fixed obligation, funded without regard to the employers financial condition.
Ideal Scenario Establishing a DB plan is most advantageous for a corporation with stable or growing earnings and shareholder-employees age 50 and older with long service records. The corporation should have the financial resources to meet the DB plans funding requirements for at least five (preferably, 10) years, to avoid IRS arguments that the plan was not intended to be permanent when adopted.
Advantages The advantages of a DB plan are: 1. The employer generates current tax savings, while accumulating retirement benefits primarily for the owners. 2. Shareholder-employees avoid current taxation on the benefits being funded for them. 3. Shareholder-employees account balances will increase dramatically over a relatively short period, due to large employer contributions and tax-deferred earnings thereon.
Disadvantages There are some significant disadvantages to DB plans. The administrative costs can be significantly higher than those for other plan types, due to the requirement to obtain actuarial services annually. Also, the employer will bear the burden of any investment losses, in the form of increased funding requirements. Because a DB plan guarantees a certain benefit, investment losses will require larger contributions to maintain those benefits. Of course, investment gains will reduce the employers funding requirements.
Example David, Mark and John own Boxcorp, a calendar-year C corporation. Over the past five years, sales have doubled and net profits have tripled. The owners want to maximize their accumulation of retirement dollars and the corporations deductions, because Boxcorp is in the 34% bracket. The following summarizes pertinent information for the three shareholder-employees:
In addition to the three shareholder-employees, Boxcorp has 30 rank-and-file employees whose compensation ranges from $23,000 $35,000. These employees have been with the company for nine or 10 years. Information for five of these employees is illustrated in the exhibit. Each employee represents six other individuals with identical characteristics. Boxcorp will continue to be profitable and have no problem funding any retirement plan chosen.
Planning: Because funding is not an issue, Boxcorp should select a plan that allows it to make large contributions (resulting in larger tax deductions and higher retirement benefits for the shareholder-employees). Because the corporation has a relatively short period in which to fund the shareholder-employees retirement accounts (all three shareholder-employees are in their 50s), a DB plan is probably the best option. However, Boxcorp will be obligated to fund DB contributions annuallyi.e., it cannot make a contribution in one year and skip the next. |
