Options for Retirement and Minimizing Income and Estate Taxes
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Options for Retirement and Minimizing Income and Estate Taxes

When looking to save for your retirement, there are more options available for a small business owner to take advantage of.

By Lance Wallach, CLU, ChFC, CIMC

Many owners of mature small businesses put off saving for retirement while they invest time and money in their successful businesses or professional practices. With stable profit growth, they look to retirement plans to reduce current taxes. Unfortunately, a typical qualified retirement plan may be subject to a $35,000 contribution limit, while other plans limit contributions to only 15% of pay or perhaps $10,500 of salary deferrals, often with a small matching contribution. Another important limit is that, regardless of how much is actually earned; only $170,000 of compensation may be considered when designing a plan.

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  • In the competitive environment of personal financial planning, the planner who can provide for the long-term tax reduction and planning needs of his or her clients will be in demand to undertake this difficult and never ending task. In this circumstance, being aware of the available appropriate custom designed tax-oriented strategies and concepts enable the planner to point clients in the proper direction.

    Several sophisticated methods are available to handle certain tax problems resulting from an over-funded pension plan or excess accumulations in a corporation; the need to move wealth to the next generation in the most tax-efficient manner; or a desire to reduce income and estate taxes. When properly constructed, two programs can substantially reduce taxes for almost any type of business entity. The IRC Section 412(i) plan and the 501(c)(9) tax exempt trust, commonly referred to as the voluntary employee’s beneficiary association (VEBA).

    The 412(i) Plan
    The 412(i) plan is a type of qualified retirement plan funded entirely with specially designed, guaranteed insurance company contracts. Contributions are determined to fund a known retirement benefit using the guaranteed rates in the contracts, which are usually much lower than the actuarial assumptions in a typical defined benefit plan. The result is the largest contribution and tax deduction available in a qualified retirement plan.

    Consider, for example, a 55-year-old small-business owner earns $170,000 or more and plans to retire at age 65. The following annual contributions are possible:

    Another advantage is that over-funded defined benefit plans can be converted to 412(i) plans, possibly eliminating much or all of the excess assets and restoring a current tax deduction.

    Likely Beneficiaries
    Who should consider a 412(i) plan? Several entities could benefit from a 412(i) plan. They include:

    • Small businesses or professional practices with fewer than 7 employees.
    • Business owners over age 45.
    • Over-funded defined benefit plans.
    • Business owners looking for the maximum allowable tax deduction.

    The VEBA
    A VEBA is a tax-exempt organization described in IRC Sec. 501(c)(9). Operating a VEBA requires a letter of determination from the IRS stating it has received tax-exempt status. A VEBA usually provides for the payment of life, accident, health and other benefits to members of the VEBA or their dependents or beneficiaries.

    The simplest way to gain the benefits of a VEBA is to join an existing multiple-employer VEBA that already has an IRS letter of determination. A multiple-employer VEBA must have at least ten employers located in three contiguous states. Be aware that clients lose some control of funds when they join a multiple-employer VEBA. Almost any business can adopt a multiple-employer VEBA for the benefit of its employees, including owner-employees. An employer with one employee (even his or her spouse) can have a VEBA.

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    VEBAs are not subject to the rules for qualified retirement plans. For example, distributions made from a VEBA prior to age 59 1/2 are without penalties. You can contribute as tax-deductible much more than the $35,000 per year contribution limit of defined contribution plans. A VEBA contribution can be made in addition to a pension contribution. Furthermore, a business can make substantial VEBA contributions even if it is making maximum pension contributions. One program has nothing to do with the other.

    A VEBA provides several significant business planning opportunities. It allows for large, flexible and fully tax deductible contributions. In addition, assets can accumulate and compound on a tax-deferred basis and are protected from creditors. Although the plan can provide life, sickness, accident, long-term care, and educational benefits to its members, there is no vesting of benefits unless an event occurs that triggers the payment while an employee is a participant.

    VEBA participants have no “incidents of ownership” in the assets, including the life insurance contracts held by the VEBA trustee. Consequently, death benefits can be designed so that they will not be subject to income and estate taxes. To avoid the estate tax inclusion, a participant should make an irrevocable designation of beneficiary, such as a trust, for the benefit of his or her family.

    VEBA Look-alikes: Caveat Emptor
    Let the VEBA buyer beware. Trusts are available that look like VEBAs. However, they have not received a letter of determination from the IRS, and many may not have applied for one. In addition, they may not comply with the IRC Sec. 505 nondiscrimination rules or with ERISA requirements. The IRS is on the look out for abusive plans. The IRS has challenged such plans (for example, Booth vs. Commissioner, 108 TC No. 25, Tax Court docket no. 22544-94, June 17, 1997) and there probably will be more challenges.

    What do planners and clients need to watch for? If a VEBA plan’s benefits seem too good to be true, they probably are. For example, in a recent case involving a neonatology practice, the promoters promised tax deductions going in and tax-free withdrawals later on. The result was the loss of the deduction. Watch out, similar plans are being marketed.

    Who Should Consider a VEBA?
    The numerous benefits of a VEBA trust may make joining a multiple-employer VEBA plan suitable for the following types of businesses and business owners:

    • Businesses and individuals that would like to protect their assets from creditors, especially those in high-liability businesses and professions.
    • Profitable businesses that want to reduce their tax liabilities.
    • Companies that can no longer make contributions to their qualified retirement plans because the plans are over-funded or no longer favor the business owner.
    • Individuals looking to reduce, eliminate, or provide liquidity for estate taxes.
    • Businesses looking to supplement or enhance their business-succession plans (for example, by using the death benefit in the VEBA as a more tax-efficient method of providing cash to beneficiaries and avoiding the disruption of the corporation’s cash flow).
    • Physicians, dentists and other high-income professionals.

    For clients looking for the maximum current tax deduction the 412(i) plan or the VEBA may be the perfect solution. They are perhaps two of the most powerful, yet underutilized, business and personal financial planning tools.

    The information provided herein is not intended as legal, accounting, financial or any other type of advice for any specific individual or other entity. You should contact an appropriate professional for any such advice.

    Mr. Wallach wrote this article in response to a large volume of telephone calls requesting additional information and more technical information on this subject. This article answers some of the frequently asked questions. Lance Wallach speaks and writes extensively about how CPAs can use VEBAs to gain new clients. For complimentary copies of his technical articles on the subject, call 516-935-7346 or fax 516-938-6330.

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