Businesses of all sizes are continually seeking ways to optimize their financial strategies, including and especially minimizing their tax burdens. Defined benefit plans (“DBPs”) offer a valuable avenue for businesses to unlock substantial tax benefits while simultaneously providing retirement benefits to employees. This article explores the tax advantages of defined benefit plans for S Corporations – especially sole owner/sole employee S Corps – and highlights their implementation for tax efficiency.
Understanding Defined Benefit Plans
Defined benefit plans are employer-sponsored retirement plans that guarantee employees a specific retirement benefit based on factors such as age, years of service, and salary history. They are essentially company pension plans. As such, an actuary must determine the appropriate range of DBP plan contributions for the year in question – usually expressed as a low, medium, and high contribution ranges where the actuary also provides the recommended contribution.
These plans differ from defined contribution plans, such as 401(k)s, which rely on individual contributions of employees and employers and investment returns. Instead, defined benefit plans provide a predetermined retirement benefit to eligible employees.
Note that you can combine a 401k with a defined benefit plan such that you have both, something that many S Corporations do when adopting a defined benefit plan. If you do combine the two types of plans, there are special tax rules around the 401k profit-sharing contributions that generally limit the profit-sharing contribution to 6% of the employee’s W-2 wages.
Tax Advantages & Considerations for S Corporations
Best Candidates: Not all S Corporations are alike. Generally, good candidates for DBPs are sole owner/sole employee S Corporations with a healthy business bank account, larger W-2 compensation, and the desire to defer more income into retirement. The more employees an S Corporation has, generally the more expensive the DBP becomes. Also, if the W-2 income for the sole owner has historically been too low then likely the DBP contribution range will be too small to make it worthwhile.
Tax Deductions: S Corporations can benefit from significant tax deductions by contributing to defined benefit plans which generally allow much greater contributions than the max 401k contribution alone (max of $66,000 for 2023 when including the profit-sharing contribution). Contributions made by the business are generally tax-deductible as a business expense, effectively reducing the business’s taxable income. S Corporations also have the advantage of not having the DBP deduction limited by the company’s net taxable income – something that sole proprietorships are indeed limited by.
Tax-Deferred Growth: Contributions made to defined benefit plans grow on a tax-deferred basis until distribution. This tax advantage allows the business’s plan to accumulate and compound over time, potentially leading to significant growth and enhanced retirement benefits for employees.
Accelerated Retirement Savings: Defined benefit plans enable businesses to accelerate retirement savings for employees. Contributions to DBPs can be considerably higher compared to defined contribution plans, allowing for faster accumulation of retirement assets. Both current and future year DBP deductions may be higher for S Corporations than other types of tax entities since it’s only dependent on paying the S Corporation sole owner/employee a W-2 salary (as opposed to net taxable income). Future deductions may also be increased for the same reason as the DBP contribution is generally based on the 3-year compensation average, which for S Corporations is based on W-2 wages instead of net taxable income.
Implementing Defined Benefit Plans for Businesses
Professional Guidance: Implementing a defined benefit plan requires specialized knowledge and expertise. Engaging retirement plan professionals, such as financial advisors and tax consultants, is important in determining whether a DBP makes sense for you and your business given your financial, retirement, and tax goals. They can evaluate the feasibility and potential tax advantages specific to the business and provide guidance throughout the process, and both before and after implementation.
Actuarial Analysis: As discussed earlier, an actuary must be involved to determine the required contribution levels to fund the promised retirement benefits adequately. Actuaries utilize various factors, including employee demographics and expected investment returns, to calculate the ranges of appropriate contributions for each tax year.
Compliance and Reporting: Businesses must ensure compliance with applicable retirement plan laws, regulations, and reporting requirements, such as the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code. Working closely with professionals and plan administrators specializing in retirement plan compliance helps ensure adherence to these regulations.
Plan Customization: Customizing the defined benefit plan to align with the specific goals of the business is crucial. Considerations include the desired retirement benefits, eligibility requirements, vesting schedules, and integration with other retirement plans, such as 401(k)s or profit-sharing plans.
Defined benefit plans offer S Corporation’s a powerful tool to maximize tax efficiency while providing valuable retirement benefits.
Implementing and managing defined benefit plans can be complex, requiring professional guidance and expertise. However, when planned and executed correctly DBPs can provide significant tax savings and retirement benefits. Financial advisors, actuaries, and tax consultants can provide the necessary knowledge and support to navigate the intricacies of these plans, ensuring compliance and maximizing the tax-savings potential for S Corporations. Please consult with your advisory team especially your financial advisor to determine the viability of a DBP for your business and contact us today if you are interested in tax planning for your company’s retirement options.