5 retirement plans every financial advisor should knowArticle added by Nicholas Paleveda MBA J.D. LL.M on June 13, 2014
Nick Paleveda MBA J.D. LL.M

Nicholas Paleveda MBA J.D. LL.M

Sanford, NC

Joined: March 27, 2012

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Here are the top five retirement plans every financial advisor, CPA and attorney must know:

5. The DB/DC combination

Imagine a client would like to set up a pension plan for himself, but not all his employees. Can he do this?

The answer is yes. Set up a defined benefit plan “cross tested” with a defined contribution plan, or DB/DC combination. The “old” rule 401(a) (26) placed into ERISA in1974 states the defined benefit plan must include 40 percent of the eligible employees to pass the “minimum participation” test. This means you can exclude 60 percent from the defined benefit plan.

Example: Company A has two doctors, two spouses and six employees. The two doctors and two spouses are in the defined benefit plan and the six employees are excluded from the defined benefit plan.

However, excluding does not mean you can ignore these employees for testing other sections of the Internal Revenue Code. The plan must pass the “minimum aggregation allocation gateway” test. In English, this means the employees must generally receive 7.5 percent of pay, generally in a profit sharing plan. The plan must also pass 401(a) (4) independently, which means EBARS and rate groups need to be established.

This is a plan you should not try at home. Engage an “enrolled actuary” (according to Google there are 4,700 in the U.S.) to perform these tests. However, the results can be favorable for a client who is interested in a tax deduction of up to $350,000 (in some cases). The defined benefit plan allows tax deductible contributions which are not subject to the $52,000 limit, but actuarially calculated.
4. 404(o) plan

Imagine a client has a large gain in year one and would like to defer the tax, but is not sure about future gains. What can you do?

In the Pension Protection Act of 2006, Congress placed into the code section 404(o) which allows for funding a defined benefit plan, or in this case “overfunding” a defined benefit plan up to 50 percent — known as a cushion.”

Kevin Donovon, CPA, MBA, EA, an enrolled actuary, demonstrated how this can be used in a small business to capture a huge windfall in year one and ride the cushion down in the next four years. His paper was presented at the Annual NIPA conference in Las Vegas in 2012. Did you miss the conference? (You can view his PowerPoint presentation here.)
3. The Revenue Ruling Rule 2014-2015 captive

Imagine a client has a company with about $500,000 to $1 million in profits. They also have a retirement plan. Can they keep from paying taxes on the $1 million and keep the retirement plan solvent at the same time?

The answer is yes. Set up a captive.

Captive insurance companies have been around for a long time. In fact, most of the Fortune 500 companies have established captive insurance companies. However, in Rent-A-Center, 142 T.C. No. 1 United States Tax Court, February 2014, is recent. Below is the holding from the case.

Rent-A-Center corporation is the parent of numerous wholly owned subsidiaries including L, a Bermudian corporation. P conducted its business through stores owned and operated by its subsidiaries. The other subsidiaries and L entered into contracts pursuant to which each subsidiary paid L an amount determined by actuarial calculations and an allocation formula, relating to workers’ compensation, automobile and general liability risks, and, in turn, L reimbursed a portion of each subsidiary’s claim s relating to these risks. P’s subsidiaries deducted, as insurance expenses, the payments to L. In notices of deficiency issued to P, R determined that the payments were not deductible.

Held: P’s subsidiaries’ payments to L are deductible, pursuant to I.R.C. sec. 162, as insurance expenses.

What does this mean for tax planning? In a captive that maintains the 831(b) election, the first $1,200,000 in premium is not included in income. These “micro-captives” allow company A to transfer risk to company B which they control and receive a $1,200,000 deduction. Employees do not have to be included in this plan. Of course the company has to “insure” risk of the parent and operate as an insurance company. Today, the captives may be incorporated in the U.S., with Vermont being the leader and Utah and Florida updating their statutes to compete for “captive” formations.

What does this have to do with retirement plans? Even more recently, in May of 2014, the IRS issued Rev. Rul. 2014-15, which allows a captive to insure the risks of an employee benefit plan.
2. The "self-directed" IRA

Imagine a client has a large IRA rollover. They would like to invest in the new crowd funding deals. Can they do this? The answer is yes.

“Before IRA money is invested in a crowd funding offering, the parties involved (investor, offering company, portal) should be aware of the following issues that are unique to crowd funding where an IRA is involved,” said Matt Sorenson, attorney and author of the “Self Directed IRA Handbook."
  • UBIT tax There is a tax that can apply to an IRA called unrelated business income tax (UBIT). IRC 512. This tax doesn’t apply to IRAs in passive investments like rental real estate, capital gains, or on dividend profits from a C-Corp (e.g. what you get from publicly traded stock owned by your IRA), as those types of income are specifically exempt from UBIT tax. However, one situation when an IRA is subject to UBIT tax is on profits from an LLC or LP where the profits are derived from ordinary income activities like the selling of goods or services. So, for example, if my IRA bought LLC units in a company that manufactured and sold a new yard tool then the profits that are returned to my IRA is ordinary income (where no corporate tax was paid) and will be subject to UBIT tax. The UBIT tax rate is 39.6 percent once you have $12,000 of annual net profits. Being subject to UBIT tax isn’t the end of the world, and there are some structuring options to minimize the tax, such as a C-Corp blocker company, which can cut the tax rate in half in many instances.

  • Avoid perks. Many crowd funding offerings promise free products or special services to the shareholders/owners that invest through the crowd funding offering. Unfortunately, these perks to self-directed IRA owners will likely constitute a self-dealing prohibited transaction and will result in disqualification of the IRA. A self-dealing prohibited transaction occurs when and IRA owner receives personal compensation or otherwise personally benefits from an IRA’s investment. IRC 4975 (c) (1) (F). As a result, perks to self-directed IRA owners should be provided only when it has been determined that they would not result in a self-dealing prohibited transaction.

  • No S-Corporations. An IRA cannot become a shareholder in an S-/corporation, because IRAs do not qualify as an S-Corporation shareholder under the tax laws. IRC 1361 (b) (1) (B). Consequently, IRAs should not invest in companies that are S-Corporations.

  • Watch out for companies owned or managed by family. The tax laws restrict your IRA from investing into companies where you or a family member (e.g., spouse, children, parents) are owners or members of management. IRC 4975(c). As a result, if the crowd funding offering is offered by a family member or if a family member is involved in management, make sure you consult with an attorney prior to investing your IRA into the crowd funding offering, as it could result in a prohibited transaction for your IRA.
1. The "Thousand Oaks" transaction

How would you like to sell your small business and not pay a tax? Perhaps defer?

Imagine a small business sale just took place. The sale is an “asset sale” and the client still owns the company. Now, the owners have cash and decide to set up a defined benefit plan to defer the gains of the sale. Will this work? According to the U.S. Tax Court, the answer is yes.

In my 2013 Case of the Year Thousand Oaks v. Commissioner, T.C. Memo 2013-10, the blueprint on how to effectively engage in this transaction was given to the taxpayer by the Tax Court. Granted, in the case, the taxpayer went a little overboard and you must, be careful. Section 162, 212, and 404 must still be followed.
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