Keep It Simple: Retirement Saving For Todays Business Owners

One of the most pressing problems for successful business owners is finding the most tax-efficient way to save for retirement. Qualified plans have contribution limits and may force owners to contribute for more people than they want.

Nonqualified deferred compensation seems attractive at first glance but is hobbled by the fact that there is no current income tax deduction for contributions and that controlling owners are prohibited from participating by ?409A of the Internal Revenue Code (IRC).

Personally owned variable universal life insurance is an attractive vehicle, but what’s the best way to get the funds out of the business? The simplest alternatives may be the best, including:

o Additional compensation for the C corporation owner;

o S corporation distributions for the S corporation owner; and

o Capital distributions for the LLC member.

There is also a new technique for C corporation owners: dividends.

Collateral Assignment Split-Dollar for C corporation Owners

Collateral assignment split-dollar (CASD), an interest-free loan for which life insurance is used as collateral, is less advantageous than it was a generation ago.

To illustrate, let’s revisit 1980. Then, the top individual income tax rate was 70%, which meant that $1 of taxable income was only 30 cents after taxes! But inside a C corporation, which was a frequent business tax election at that time, the tax on the first $25,000 of taxable income was only 17%.

For the owner in the 70% bracket doing year-end tax planning, the alternatives were clear. If the last $25,000 of taxable income was taken as a year-end bonus, $17,500 would go for income tax and only $7,500 would be left over for retirement savings.

If, however, $25,000 was left in the corporation, only $4,250 would go for taxes, leaving $20,750. That’s a potential tax leverage of $16,500. To get that money out of the corporation, you could use CASD.

You did so by borrowing the after-tax amount of $20,750 from the corporation and placing it into life insurance. You then assigned the policy as collateral for the loan.

That was fine, especially because in 1980 an interest-free loan was OK, as long as the formalities were observed. The arrangement was taxed, but only as an employee benefit, based on the net life insurance coverage and the insurer’s lowest published annual renewable term insurance rates.

Things have changed:

o Tax rates have declined. The top individual bracket is now 35% and the rate on the first $25,000 (actually $50,000) of C corporation taxable income is 15%.

o All wages are subject to the Medicare tax, 1.45% on the employee and 1.45% on the employer. That yields an additional 2.9% of tax for the 100% owner of a C corporation.

o The final split-dollar regulations have acknowledged that CASD is a loan for tax purposes and that IRC ?7872, which deals with below-market rate loans, applies to CASD. Section 7872 says that an interest-free loan confers a valuable, taxable and economic benefit on the borrower and that the benefit is measured by the interest the borrower doesn’t have to pay.

The benefit, called imputed interest income, doesn’t have to be paid to the lender by the borrower, but the borrower does have to pay income tax on the benefit. In the context of our business owner–an employee of the C corporation–the imputed interest income would be taxed as additional compensation.

The result? First, tax leverage has dropped dramatically. Combining the income tax and Medicare taxes, the year-end bonus of $25,000 is now $15,525 after taxes. If the bonus isn’t taken, the after-tax profit is $21,250.

That makes the potential tax leverage $5,725–a lot less than the $16,500 of 1980. Also, the tax on the imputed interest income will be substantially greater than the tax on the life insurance coverage, as it was under the old rules.

There are other problems with the CASD scenario. For one, it’s a loan. If our CASD arrangement is to last 20 years, the balance due will be $425,000 ($21,250 X 20 = $425,000) at termination.

The business owner probably won’t repay the loan in cash, but rather through additional compensation. That’s a big expense deduction. And it raises several important questions:

o Will the business generate enough income to benefit from the deduction?

o Would such a large compensation deduction withstand IRS scrutiny?

o Would the loan withstand IRS scrutiny?

o Will the documentation be adequate to withstand an IRS audit?

o What will future tax rates be?

o Are there 409A implications?