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George F. Bearup, J.D. Senior Legal Trust Advisor

4-Mar-19

IRC 199A- Defined Pension Planning

Take-Away: More and more small business owners look for ways to restructure their business (S corporation or LLC) in order to be able to claim an IRC 199A 20% deduction from their qualified business income. One planning step that should be considered is the adoption of a qualified defined pension plan for the small business, or a cash balance retirement plan.

Background: Heads are spinning as business owners and their advisors try to understand the eligibility requirements to claim the IRC 199A 20% income tax deduction. While Treasury’s Regulations are designed to assist in understanding and implementing IRC 199A, those Regulations have only caused even more confusion with some of the examples used. IRC 199A uses income limitations, income phase-out rules, it excludes many businesses based on the type of service they provide from claiming the income tax deduction, and it subjects the amount of the available IRC 199A income tax deduction to limitations with regard to: (i)W-2 wages paid and (ii) tangible property capital asset acquisitions placed in service.  Bewilderment is the operative word when dealing with the IRC 199A eligibility rules and how to assist a business owner to optimize a claimed income tax deduction.

Pension Plan Contributions: Some commentators have suggested using a defined benefit pension plan as one ‘tool’ to enhance the ability of a small business owner to claim an IRC 199A income tax deduction. This suggestion of using a pension plan comes into play two separate ways:

  • Wages Paid Test: As noted above, one limitation imposed on the amount of a business owner’s claimed IRC 199A income tax deduction is what is called the wages paid test. As a gross generalization, the larger the W-2 wages a business pays, the larger the IRC 199A deduction it might be able to claim.  For purposes of applying the wages paid test, pension plan contributions and health care plan contributions made by the business are considered wages paid. Consequently, many businesses may have enlarged wages paid to enhance their income tax deduction eligibility simply by including these pension and health care contributions as wages paid by the business.
  • Reduce Service Provider’s Reported Income: Some of the ‘excluded’ service providing businesses, e.g. a physician or dentist, who are normally excluded from claiming an IRC 199A income tax deduction, might make themselves eligible to claim the deduction if their professional or qualified business income is lowered. The goal, following IRC 199A’s income limits, is to reduce the married professional’s income to below the $315,000- the IRC 199A threshold amount. Limiting the professional’s taxable income might enhance their opportunity to take the 20% pass-through income tax deduction that is permitted under IRC 199A. The point is that pension plan contributions will reduce the income-profit of the professional, yet those contributions will significantly add to the professional’s tax qualified accounts. Obviously, any pension contributions would also reduce the professional’s income that is subject to state income taxes, which might not be deductible because of the new SALT limits on itemized income tax deductions.
  • Option to Other Strategies: Some of the other planning strategies that are being touted as possible solutions to deal with IRC 199A, and its income limitations may not be available to an individual who wants to restructure his/her business in order to qualify for the 199A income tax deduction. For example, the Regulations limit the use of multiple non-grantor trusts to hold partial business interests and also avoid any taxable income threshold the business owner might otherwise face. A pension plan contribution reduces reported income of the owner without triggering scrutiny that the multiple non-grantor trusts, created for the sole purpose of qualifying for the IRC 199A income tax deduction will cause. In addition, licensed professionals may not be able under state law to transfer equity interests in their professional practices, so that even if creating multiple non-grantor trusts might work from an income tax deduction perspective, they may not be a legally viable option for the professional.

Cash-Balance Plan Solution?  Thus, one strategy  some small pass-through business owners should consider is the adoption of a cash-balance pension plan. This type of qualified retirement plan is often referred to as a hybrid pension. That is because its benefit formula and payment method looks much like a defined contribution pension plan. Each year the employer-sponsor makes a contribution to the participant’s hypothetical account balance, which is essentially a notional bookkeeping account that is used to determine the participant’s benefit entitlement. The contribution made by the employer-sponsor is credited to the participant’s account based upon a percentage of the participant’s compensation, but it can also be a flat dollar amount, or a variable amount that is based upon the participant’s age and/or years of participant service with the employer-sponsor.

  • Contributions Deductible: Income tax deductions are permitted by the employer-sponsor within the limits of IRC 404 and 415 for contributions to the cash-balance pension plan.
  • Variable Annual Contributions: Unlike other types of qualified plans, contributions to the cash-balance pension plan made by the employer-sponsor can vary from year to year as long as the benefit accrual rules of the Tax Code are satisfied.
  • Benefit to Business Owner: A cash-balance pension plan usually bases the employer-sponsor’s contributions on a plan participant’s compensation for that particular plan year, rather than the participant’s final average compensation amount. As a result, the employer-sponsor’s contributions to the cash-balance pension plan usually increase with the age of the business owner.
  • Vesting: The vesting schedule under a cash-balance pension plan must be a ‘3-year cliff’ vesting, which means no vesting in the participant for three years, and 100% vesting after three years of participant service.

IRC 401(h): Also often overlooked is a medical retirement plan under IRC 401(h) which is often ‘tied’ to an employer’s cash balance plan. This permits contributions to a separate account on behalf of an employee-participant to set aside funds for the participant and his/her spouse, and their dependents medical expenses in the participant’s retirement years. This type of plan functions much like the cash balance plan, but very large tax deductible contributions can be made to this 401(h) plan to effectively ‘pre-fund’ medical expenses in retirement years. As a result, contributions to the 401(h) plan in conjunction to the cash balance plan, which will be treated under IRC 199A as ‘wages paid’ can go a long way to assist a professional or other small business owner qualify for the IRC 199A income tax deduction.

Conclusion: As many professionals begin to understand the limits of IRC 199A and their inability to restructure their businesses to become eligible to claim the IRC 199A deduction due to the restrictions found in either the 199A Regulations or state laws that prohibit unlicensed persons from holding equity positions in professional practices, some consideration should be given to adopting a cash balance pension and 401(h) plans for the reasons outlined above. Not every professional will be interested in this option, but some will at least consider the cash balance pension and 401(h) plans as a way to reduce their reported income, and increase the wages paid, to become eligible to claim the income tax deduction while concomitantly increasing their retirement assets.