Year-end Tax Planning Opportunities - Oct. 2009


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Web Seminar discussing important year-end tax planning opportunities for organizations who sponsor a retirement plan for their employees

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Year-end Tax Planning Opportunities - Oct. 2009

  1. 1. Making the most of Year-end Tax Planning Opportunities<br />
  2. 2. Agenda & Speakers <br />Cash Balance and Creative Plan Design Ideas<br />Rose Panico-Marino, Executive Managing Director<br />Larry Butcher, Director<br />ESOPs – A Tax Favored Ownership Transition Vehicle<br />Nancy K. Dittmer, Managing Director<br />Targeted Retention Incentive Plans (TRIPs)<br />Steve Levin, Managing Director<br />Wrap Up<br />
  3. 3. Cash Balance and Creative Plan Design Ideas<br />Rose Panico-Marino, Executive Managing Director<br />Larry Butcher, Director<br />
  4. 4. The Power of Plan Design<br />Business owners and executives often seek to maximize contributions to their tax-qualified retirement accounts in order to:<br />Accumulate sufficient assets for their future retirement years<br />Reduce current income tax liabilities<br />Make up for investment losses in recent years<br />BUT…<br />Proportionately higher contributions for staff are usually not affordable<br />Solution:<br />Customized plan provisions can focus on maximizing contributions for owners and executives while controlling contribution costs for other eligible employees<br />4<br />
  5. 5. The Power of Plan Design<br />Advanced plan design techniques can achieve greater tax savings and value for plan sponsors<br />Effective adoption agreement analysis and plan document design methods can have positive impact on the overall success of the plan<br />Working with a knowledgeable retirement plan consultant gives you access to ideas not found with “in the box” providers<br />5<br />
  6. 6. Maximizing owners under defined contribution (DC) plans <br />Maximum allowable contributions under a DC plan<br />$49,000 in 2009<br />$54,500 if age 50 or older and if plan includes 401(k) provisions<br />If this contribution level is sufficient for the business owner, contribution costs for other eligible employees can be controlled by:<br />Using safe harbor 401(k) provisions to get maximum leverage out of the owner’s 401(k) salary deferral contribution<br />Using a class-based method to allocate the employer-funded contribution so the owner(s) get a higher contribution rate than other plan participants<br />6<br />
  7. 7. Going beyond the contribution limits of a DC plan<br />Contributions higher than the $49,000/$54,500 limits of a DC plan require the addition of a defined benefit (DB) pension plan <br />DB/DC combo is a 401(k)/profit sharing plan paired with a separate defined benefit pension plan<br />The 401(k) plan often has safe harbor provisions so owners can maximize their salary deferral contributions<br />Both plans provide different contribution or benefit levels for owners than for other plan participants<br />The defined benefit plan can be a traditional DB plan or a cash balance DB plan<br />Cash balance DB plans are now widely used in DB/DC combo arrangements<br />7<br />
  8. 8. DB/DC combination plans<br />Not a type of plan<br />Pairing of two plans together to achieve desired contribution results<br />Think of this as a “Super Age-Weighted” Plan<br />Provides: <br />Significant increase in maximum allowable contributions and benefits for owners<br />Relatively modest additional contributions and benefits to other plan participants<br />Tax savings on additional contributions for owners often more than offset additional contribution costs for staff<br />8<br />
  9. 9. DB/DC combination plans – non-discrimination testing<br />Contributions or benefits provided under the combined plans must not discriminate in favor of Highly Compensated Employees (HCEs)<br />How do these plans pass non-discrimination testing? <br />DB and DC plans are tested on a combined basis as if a single plan <br />Single combined plan tested on a benefits basis, instead of contribution basis<br />Employer contributions in DC plan are converted into benefits payable at retirement age and then combined with benefits provided under the DB plan<br />If combined benefits did not discriminate in favor of HCEs, then EACH plan is deemed to be non-discriminatory.<br />9<br />
  10. 10. DB/DC combination plans – participation and coverage requirements<br />Minimum requirements<br />DB plan must provide meaningful benefits to the lesser of 50 employees or 40% of employees who satisfy statutory minimum age and service requirements<br />At least 70% of all eligible employees must benefit under both plans<br />Each staff employee must receive a contribution of at least 5% of pay per year under the defined contribution portion of a DB/DC combo.<br />10<br />
  11. 11. Case study - Physician Group <br />ABC Radiologists<br />3 owner-physicians and 27 staff employees <br />Consistently profitable practice<br />Current retirement plan<br />Traditional profit sharing plan<br />Pro-rata allocation method<br />Contribution set at level needed to maximize owners each year<br />Owners’ objectives:<br />Maximize annual contributions for owners<br />Control cost of contributions for staff<br />11<br />
  12. 12. Case Study – Physician Group - DC Plan Only <br />Reduce staff contribution costs through plan design, using DC plan only<br />1 Excludes catch up contributions<br />2 Assumes safe harbor 401(k) with QNEC of 3% and profit sharing contribution of 10.27% <br />12<br />
  13. 13. Case Study – Physician Group - DC Plan Only <br />Reduce staff contribution costs through plan design, using DC plan only <br />1 Excludes catch up contributions<br />2 Assumes safe harbor 401(k) with QNEC of 3% and profit sharing contribution of 10.27% <br />13<br />
  14. 14. Case Study – Physician Group - DC Plan Only <br />Reduce staff contribution costs through plan design, using DC plan only<br />1 Excludes catch up contributions<br />2 Assumes safe harbor 401(k) with QNEC of 3% and profit sharing contribution of 10.27% <br />14<br />
  15. 15. Case Study – Physician Group – Using DC Plan Only<br />Result of plan design changes, using DC plan only<br />Owners’ contributions remain at DC plan maximum - $49,000<br />One owner’s contribution increased by $5,500 - 401(k) catch-up amount<br />Minimum required contribution for staff decreases significantly<br />From 20% of pay to 5% of pay<br />From $165,400 to $41,350<br />Annual staff contribution cost reduction - $124,050<br />Higher profit sharing contribution for the staff is allowable, but no longer required to support the maximum contribution amounts for the owners<br />
  16. 16. Case Study – Physician Group – Using DC Plan Only<br />Improved DC plan design met only one of the owners’ two objectives<br />Significantly reduced the contribution costs for staff, but<br />Did not increase the annual contributions for the owners<br />Must add a defined benefit plan in order to increase the owners’ contributions beyond the $49,000/$54,500 maximum of a DC plan<br />
  17. 17. Case Study - DB/DC Combo for Physician Group <br /> Increase owners’ contributions through plan design – DB/DC combo <br />1 Excludes catch up contributions<br />2 Assumes safe harbor 401(k) with QNEC of 3% and profit sharing contribution of 2.0% for staff, 13.26% for physicians <br />3 Cash Balance Plan with Benefits Payable at 62 and Safe Harbor 401(k) with a Cross Tested Profit Sharing Plan<br />NOTE: As a result of the funding rules of The PPA of 2006, a slightly lower contribution is expected for the benefits accrued by Highly Compensated Employees for the first year of the plan. Future years&apos; contributions will likely increase.<br />17<br />
  18. 18. Case Study – DB/DC Combo for Physician Group<br />Result of plan design changes, using DB/DC combo <br />Owners’ annual contributions increased significantly over DC-only plan<br />Dr. Adams went from $54,500 to $172,160, an increase of $117,660/year<br />Dr. Baker went from $49,000 to $143,410, an increase of $94,410/year<br />Dr. Cox went from $49,000 to $77,260, an increase of $28,260/year<br />Total increase in owners’ contributions over DC-only plan: $245,830/year <br />
  19. 19. Case Study – DB/DC Combo for Physician Group<br />Result of plan design changes, using DB/DC combo <br />Staff contribution costs higher than in optimized DC-only plan<br />$82,700 for staff in DB/DC combo, compared to $41,350 in optimized DC plan<br />$245,830 increase in benefits for owners offset by cost increase of $41,350 for staff, leaving a net gain of $204,480 for owners<br />Staff contribution costs in DB/DC combo still 50% lower than under the original profit sharing plan<br />$82,700 for staff in DB/DC combo, compared to $165,400 in original DC plan<br />
  20. 20. DB/DC Combos – Picking the Right Opportunities<br />Cash balance and class-based DB/DC plan designs work best when there is one target employee who is at least 48 years old and no more than 10 staff employees who are mostly younger than the target<br />Quick Math: <br />A 48-year-old target can get up to $160,000 in total annual contributions<br />Contributions for 10 staff: 8% of pay x 10 x avg. comp of $35,000 = $28,000<br />Tax savings on total contribution: $188,000 x 35% = $65,800<br />Tax savings for employer are greater than contributions for the staff<br />Works well for groups of target employees as long as there is a maximum 10:1 ratio of staff to target employees<br />
  21. 21. Power of Plan Design – Target Market (DC only or DB/DC)<br />Physician Groups, Dentists<br />Attorneys, Architects<br />Investment Management Groups<br />Any small closely-held business with consistent income/profitability<br />A plan that lists code 2A on line 8 of Form 5500 as a plan characteristic is using a class-based allocation method<br />
  22. 22. ESOPs – A Tax-Favored Ownership Transition Vehicle<br />Nancy K. Dittmer, Managing Director<br />
  23. 23. An ESOP is a possible solution for business owners who<br />are not ready for a complete ownership transition but are looking for partial diversification of their personal net worth<br />are concerned federal capital gains tax rates will increase and would like to sell a portion of the business at current rates<br />are looking for complete ownership transition but <br />have not been able to locate a buyer or <br />are concerned about the impact on employees and/or community<br />
  24. 24. An ESOP is a possible solution for business owners who<br />are looking for a tax-favored opportunity to sell all or a portion of the business in light of increases in the federal capital gains tax rate<br />would like to sell all or portion of the business to employees who lack the funds to purchase the business<br />are need of additional capital and would benefit from a tax-favored financing arrangement<br />
  25. 25. An ESOP is…<br />A type of qualified retirement plan (e.g., similar to a 401(k) plan)<br />With specific tax advantages that may apply to a shareholder selling to an ESOP.<br />That can borrow funds needed to acquire company stock.<br />With specific tax advantages that apply to the company sponsoring the ESOP to make the acquisition of the company stock more affordable.<br />
  26. 26. How a Typical ESOP Works<br />Employer obtains a loan from a commercial lender <br />Employer lends money to ESOP as a securities acquisition loan <br />ESOP uses loan proceeds to purchase employer securities<br />Employer contributes cash annually to the ESOP to service the loan<br />Because the contribution to the ESOP is tax deductible as a retirement plan contribution, the principal payments on the securities acquisition loan are essentially tax deductible<br />I.e., all payments made on the debt incurred to fund the buy out of a shareholder are deductible<br />Shares of company stock are allocated to participants accounts over time<br />(e.g., a 7 year loan term would result in 7 years of share allocations to employees) <br />
  27. 27. Other Tax Advantages of an ESOP<br />A shareholder of a C corporation may be able to sell stock to the ESOP without current taxation of the gain on the sale<br />Dividends paid on C corporation stock held by the ESOP may be tax deductible<br />If the plan sponsor is an S corporation, there is no Federal income tax on the portion of the S corporation’s income allocated to the ESOP<br />
  28. 28. Tax Deferred Sales to ESOPs (1042 Sales)<br />Shareholder sells C corp stock to ESOP and invests proceeds in “qualified replacement property” <br />Tax on the gain is deferred. <br />The basis in the stock sold carries over to the replacement property but if such property is held until death, there is a step up in basis so that the capital gains tax can be avoided completely. <br />Qualified replacement property often structured as floating rate notes<br />The ESOP must own 30% of the company after such sale<br />There are restrictions applicable to ESOP - <br />Selling shareholders<br />Certain family members <br />More than 25% shareholders will be prohibited from participating in the ESOP <br />
  29. 29. Case Study #1 – Mr. Clyde <br />Mr. Clyde owns 100% of Clyde, Inc. (a C corporation). He is 62 and while not ready to retire, his investment in Clyde, Inc. is the vast majority of his net worth and he is looking for partial liquidity now. <br />The value of Clyde, Inc. is $10 MM. His basis is $1 MM. <br />If he were to sell 30% to the ESOP and elect the Section 1042 tax deferred rollover, he can defer the tax on the $2,700,000 gain. <br />The ESOP would borrow the $3 MM needed to buy the shares. Both the interest and principal paid on this loan would be deductible to Clyde, Inc. (assuming the payments are within the contribution limits applicable to qualified plans.) <br />The selling shareholder has achieved diversification in the amount of $3 MM. <br />The selling shareholder has deferred tax on a gain of $2,700,000!<br />The company has been able to deduct the principal payments of $3MM!<br />
  30. 30. Case Study #2 – Ms. Style <br />Ms. Style owns 70% of S+12, Inc. (an S corporation). There are 12 minority shareholders. Ms. Style is ready to retire completely, sail off in the sunset and would like to completely liquidate her holdings. She is also concerned about future increase in the capital gains tax rate so she wants the company to buy her out as soon as possible. The 12 minority shareholders are not financially able to purchase her entire interest at this time. <br />Assume value of company = $20,000,000<br />Assume taxable income = $6,000,000<br />Assume annual qualified plan contributions = $350,000<br />Assume S corporation distributions equal to 45% of taxable income<br />
  31. 31. Case Study #2 – Ms. Style <br />The ESOP buys 70% of the S corporation for $14 million<br />If the ESOP’s loan is amortized over 9 years @ 7.5%, the annual debt payment would be approximately $2,195,000<br />The ESOP will receive S corporation distributions of $1,890,000 that can be applied to its debt payments ($6 million x 70% x 45%)<br />The remaining $305,000 could be serviced as a retirement plan contribution, which is less than the current annual level of contribution<br />The bottom line<br />The ESOP’s purchase of shares may be funded with no net decrease in the company’s current cash flow<br />Ms. Style has accomplished her goal of cashing out completely and will pay capital gains tax at the current rates<br />
  32. 32. Tax Savings Nirvana <br />Combine the tax advantages from the prior two case studies <br />the sale occurs when the company is a C corporation, allowing the selling shareholder to defer the capital gains tax<br />Then the company can make the S election and use the tax savings of having a tax exempt shareholder to fund the debt payments!!!!!<br />
  33. 33. Non Tax Advantages<br />Culture of “ownership” and increased employee productivity<br />According to Rutgers <br />ESOPs in closely held companies appear to increase sales, employment, and sales per employee by about 2.3% to 2.4% per year over what would have been expected absent an ESOP<br />In May 2009, the Employee Ownership Foundation surveyed corporate members<br />88% of respondent companies outperformed the three major stock indices in 2008, and 65% reported that the ESOP had improved the overall productivity of their employees.<br />
  34. 34. Key Considerations<br />An ESOP is subject to nondiscrimination, eligibility, vesting requirements enforced by the IRS and DOL for all qualified plans<br />An independent appraiser must determine fair market value of company stock for any transactions and then annually <br />Discounts for lack of marketability and minority ownership may apply<br />Corporate governance<br />A trust is the legal owner of the ESOP’s shares<br />Trustee will generally vote the shares owned by the ESOP<br />In certain situations ESOP participants must be given the right to vote (merger, recapitalization, sale of substantially all of the assets, etc.)<br />An independent trustee is recommended for transactions.<br />On an ongoing basis, the trustee can be one or more “insiders.”<br />
  35. 35. Key Considerations<br />Emerging repurchase obligations<br />Employer must be able to convert illiquid asset into liquid assets upon termination or retirement of ESOP participants<br />ESOP companies should attempt to project this obligation and evaluate funding options every 3 to 5 years <br />Financial accounting for a leveraged ESOP is somewhat complex<br />Code Section 409(p) – Anti Abuse<br />These rules are designed to ensure broad based employee ownership but can be a trap for the unwary<br />
  36. 36. Targeted Retention Incentive Plans<br />Steve Levin, Managing Director<br />
  37. 37. Current Economic Woes<br />Pressure on compensation<br />Salary freezes/pay cuts<br />Cash is tight<br />Yet, retention of key employees is critical<br />How can companies demonstrate their commitment to key employees?<br />Targeted Retention Incentive Plan (“TRIP”)<br />
  38. 38. Targeted Retention Incentive Plans (“TRIP”)<br />Current promise to pay future benefits<br />Benefits are contingent on continued employment<br />Limited to select employees<br />Flexibility in setting the “vesting date”<br />Benefits paid following vesting or a specified later date<br />
  39. 39. Targeted Retention Incentive Plans (“TRIP”)<br />No current cash benefits<br />Cost efficient<br />Demonstrates company commitment to the key employee<br />Can be used in any business industry and for non-profit organizations as well<br />
  40. 40. TRIP Case Study<br />ABC Company <br />Experiencing a downturn with reduced revenues and pressure on margins <br />ABC believes the downturn is tied to the slowdown in the overall economy. <br />ABC hopeful that its business will recover over the next 2 – 3 years. <br />Instituted cost containment program, including pay freeze for all employees.<br />Mary is a highly valued, experienced employee of ABC<br />Would be very attractive to a competitor company. <br />ABC wants to demonstrate its loyalty and commitment to Mary with a financial incentive to remain with ABC during this lean period. <br />ABC promises to pay her a bonus of $30,000 if she remains through December 31, 2012 (at which point the Company believes business conditions will be back to normal) .<br />
  41. 41. Related Concerns<br />Expense must be accrued<br />Benefits remain subject to creditor risks<br />Tax deduction deferred until inclusion of income<br />May need to plan for future funding<br />
  42. 42. Upcoming Web Seminars <br />Selling Stock to an ESOP – When it Works and Why<br />November 4 & 5, 2009<br />Mellody Hobson - The State of Retirement Plans in America <br />November 16, 2009<br />401(k) Boot Camp<br />Getting People Into the Plan – November 30, 2009<br />Getting Money Into the Plan – December 2, 2009<br />Getting Money Out of the Plan – December 4, 2009<br />For additional information:<br />888.RET.401K or visit us online at<br />