Tax relief for small employer retirement plans

BY JOHN W. MCKINLEY, CPA, CGMA, J.D., LL.M. AND KYLE DATOUSH

To avoid the expense of establishing a retirement plan, many small employers have left their employees on their own when it comes to saving for retirement. However, the small employer pension plan startup costs credit under Sec. 45E alleviates some of the burden by allowing a credit for establishing a qualifying retirement plan; although in some circumstances, taxpayers might find it more beneficial to take a deduction instead.  

Under Sec. 45E, a qualifying small employer may take a general business credit of 50% of up to $1,000 of qualified startup costs paid or incurred in the first credit year and each of the immediately following two tax years. Even though the credit is nonrefundable, assuming the employer meets the general business credit requirements of Sec. 38, it may carry the credit back one year or forward 20 years (Sec. 39(a)(1)). Any deduction pertaining to pension startup costs must be reduced by the credit amount. The credit is generally claimed by filing Form 8881, Credit for Small Employer Pension Plan Startup Costs. However, taxpayers whose only source of this credit is from a partnership or S corporation, and who are not themselves a partnership or S corporation, are not required to complete or file this form. Those taxpayers can claim the credit directly on Form 3800, General Business Credit (see Form 8881 instructions).

Qualified startup costs include any ordinary and necessary expenses paid or incurred by an eligible employer in connection with the establishment or administration of an eligible plan or the retirement-related education of employees with respect to the plan (Sec. 45E(d)(1)(A)). An eligible plan must have at least one participant who is not a highly compensated employee.

The first credit year is the tax year the employer plan becomes effective. However, an employer may elect to take the credit in the year preceding the tax year the retirement plan became effective. An employer might prefer to elect the preceding year if the employer paid or incurred $1,000 or more of startup costs in the prior year or, going forward, the company doesn’t expect the startup costs to last three years from the plan’s adoption. The election is made by filing Form 8881 for the preceding tax year.

“Eligible employer” has the same meaning as in Sec. 408(p)(2)(C)(i), which describes SIMPLE IRA plans. Therefore, to qualify for the credit, an employer must have 100 or fewer employees who received at least $5,000 of compensation from the employer in the preceding year (or be covered by a two-year grace period under Sec. 408(p)(2)(C)(i)(II)). If an employer is a member of a controlled group, the credit is allocated based on each member’s proportionate share of the qualified startup costs. However, if the employer or any member of the same controlled group maintained a predecessor plan during the three years preceding the implementation of the plan for substantially the same employees, the employer is barred from taking the credit (Sec. 45E(c)(2)).  

Eligible employer plans are any qualified employer plan under Sec. 4972(d), such as a Sec. 401(k) plan, SIMPLE plan, or simplified employee pension (SEP).

Whether to Take the Credit or a Deduction

The following example compares the tax benefit of the credit or a deduction.

Example. Business A has eight employees, each earning more than $5,000 a year, and decides to offer a pension plan. In its first credit year, Business A incurs $6,000 of qualified startup costs, of which it elects to apply $1,000 to the credit, for the maximum credit amount of $500 for the year. The credit directly reduces Business A’s tax liability by $500, assuming the company meets all other rules of the small employer pension plan startup costs credit and the general business credit. The election of the credit also reduces the expenses the company may net against income by $500. The exhibit illustrates this point using a marginal tax rate of 25% ($7,500 + 25% of the excess over $50,000).

 

As the exhibit shows, the election to take the credit increases taxable income by $500, resulting in a tax liability that is initially $125 greater than electing not to take the credit (at the 25% marginal rate) but subsequently reduced by the credit amount of $500. The net effect is an economic benefit equal to the after-tax portion of the credit, or $375 in this example. For taxpayers in higher marginal tax rate brackets (taxable incomes above $75,000, for this example), the tax benefit of the credit is lessened because the $500 increase in taxable income is subject to the higher rate.

Electing Not to Take the Credit

According to Sec. 38(c)(1), the general business credit cannot reduce a company’s tax to an amount less than the taxpayer’s tentative minimum tax or 25% of the taxpayer’s tax that exceeds $25,000. Therefore, the credit may not be beneficial for a business taxpayer subject to either or both of those limitations.

Taxpayers may also find a deduction more advantageous if their qualified startup costs are less than the maximum amount of $1,000 allowed under the credit and/or their general business credit is limited by the other general business credits under Sec. 38(b). Taxpayers should also consider their possible marginal tax rates in the carryback or carryforward periods to maximize tax savings. Additionally, taxpayers should consider the duration of qualified startup costs and adjust the timing of the first credit year accordingly to maximize economic benefit. Small employers should research how the pension startup costs credit might help reduce their company’s tax liability and contact their tax adviser if they are considering implementing a companywide retirement plan.

By John W. McKinley, CPA, CGMA, J.D., LL.M. ( jwm336@cornell.edu ), senior lecturer in accounting and taxation at Cornell University and adjunct lecturer in auditing and taxation at Ithaca College, both in Ithaca, N.Y., and Kyle Datoush ( kd355@cornell.edu ), CPA candidate and graduate of Cornell University.

To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.

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