What kinds of organizations can sponsor a plan? Can anyone start one? Do I Need to have employees? Does it matter if I’m the only employee, or if it’s a partnership, or if it’s a corporation? In this episode we discuss what types of organizations can sponsor a qualified plan (spoiler alert - they all can!!), and why the TYPE of organization makes a difference.
What kinds of organizations can sponsor a plan? Can anyone start one? Do I Need to have employees? Does it matter if I’m the only employee, or if it’s a partnership, or if it’s a corporation? In this episode we discuss what types of organizations can sponsor a qualified plan (spoiler alert - they all can!!), and why the TYPE of organization makes a difference.
EPISODE O: Organizations that can sponsor a plan?
Welcome to Retirement A to Z, I’m Sue Burnett w Monarch Financial Advisors, and this series focuses on Qualified Retirement Plans. There are a lot of moving pieces with these plans, and the rules are complicated and complex, so we’re going to break them into smaller pieces – 26 pieces, to be exact, from A to Z, with maybe a few extras thrown in for good measure.
This is Episode O – which will discuss what organizations can sponsor a qualified plan. Can anyone start one? Do I Need to have employees? Does it matter if I’m the only employee, or if it’s a partnership, or if it’s a corporation? Where would I deduct it on my taxes? Let’s break it down.
First off, any bona fide business can start a qualified plan. If you work for a business as an employee, and don’t have your own business, you can’t. But if you have a business, you absolutely can have a plan. It doesn’t matter if you have employees or not. It doesn’t matter if you’re a sole proprietor, or a partnership, or a LLC, or a S Corporation, or a C Corporation – any, and all, of these organizations can sponsor a plan! If you’re a W2 employee somewhere, but have a side business, you can start a plan with the income from the side business, but not from your W2 pay where you’re an employee. As long as you own a business, you can have a qualified plan.
It's extremely important to know the type of organization, though – or how the organization is taxed. Why? Because that determines what pay we use for the owners for our plan compensation. And plan compensation is used for benefit limits in all plans, in our discrimination testing when we look at the benefits provided as a percent of pay, and for the calculation of the benefit in a defined benefit plan. So compensation is pretty important!
How do we determine compensation then? For employees, it’s the same across all organizations - we use W2 pay. If the organization hires independent contractors and pays them 1099 income, that wouldn’t be plan compensation, and they wouldn’t get a benefit.
For owners, we can only use active income. Passive income isn’t considered plan pay for any owners – so, a limited owner that does’nt provide services and is just an investor in the business wouldn’t have any plan compensation. And all of an owner’s income may not be earned income – for example, investment income that is passed through the partnership to the partners isn’t counted. So we need to be really careful with what compensation we use, to be sure we’re using the right thing.
Now let’s look at the different types of plan compensation that we use, based on the type of organization that you have.
We’ll focus on the self-employed owners first – sole proprietorships and partnerships.
For a sole proprietor, business income is shown on the Schedule C, with Line 31 of the Schedule C being the net profit to the business. Plan Compensation is calculated as Line 31, - ½ of the self employment tax, - the pension contribution they’d contribute for themselves. If a sole proprietor has $100,000 on Line 31 of the Schedule C to start, they can’t contribute $100,000 to a qualified plan – then they’d have no plan compensation, right? Because their plan comp is Line 31 – pension contribution. In general a sole prop can contribute about half of what their Line 31 income is, give or take, because we need to make sure that their plan compensation stays up. It’s a circular calculation – the contributions are based on plan comp, but the plan comp is adjusted by the contribution! It goes round and round – just remember, that for a sole proprietor, you can’t just put in all of their Line 31 pay, it’s lower than that! The administrator, or your advisor, will be able to nail it down for you.
Partnerships are pretty similar to sole proprietors. Business income for partners is shown on their Schedule K-1. Plan compensation is calculated by taking their earned income from the K-1, and then subtracting off ½ the self employment tax as well as the pension contribution made for that particular partner. If there were 3 partners, and each of them were contributing different amounts to the plan for their own benefits, their plan compensation would all be different. Each partner pays for themselves, with regard to qualified plans. They all pay a prorata share for the employees, based on their ownership percentage – if they’re equal owners, they’d split up the costs equally. If one owner is 50% owner and the others are 25%, the 50% owner pays for 50% of the employee costs, and the others each pay 25%.
Now let’s talk about Corporations –. Owners of these organizations pay themselves in 2 ways – they should pay themselves a reasonable W2, and then they will also receive profits from the organization on their K1. Plan compensation for them is their W2. Period. If they’re only paying themselves $20,000, and they’re getting $500,000 in distributions, we can only use $20k to calculate the benefits due from the plan, so if the owners want bigger deductions and contributions, they may need to boost up their pay for a few years – unfortunately, this means they’re going to have to pay higher payroll tax, social security tax, etc. It’s something we talk to the CPA and the owner about, to be sure there’s the right balance of additional plan contributions vs additional taxes because of a higher W2. Owners here split the total cost based on ownership.
If the organization is a LLC, it follows the same rules we just discussed. A LLC taxed as a S Corp would follow the SCorp rules. A single member LLC would follow the sole proprietor rules.
Wrapping it all up – any organization can sponsor a plan, but the pay that we use for owners depends on the way the organization is taxed. Across all organizations, though, we only use W2 pay for employees, and we can only use active pay for the owners. And, of course, all of these contributions are a top line deduction for the business.
Wanna learn more? Tune into the other a to z podcasts where we continue to break down these wonderful and complex plans into bite size pieces. Remember, how do you eat an elephant? 1 bite at a time. Have any questions? Shoot me an email at MonarchFinancialAdvisors@gmail.com. Thx for listening in and have a great rest of your day!