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Keep It Simple: Retirement Saving For Todays Business Owners

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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?

We don’t have all the answers, but given reduced tax leverage and the increased cost of the economic benefit, it seems the bloom is off the rose of CASD as a tax-leveraging device for C corporation owners.

It would take extensive number crunching and a longer article than this one to reach that conclusion in detail. However, judging from the dramatic drop in requests for CASD illustrations for C corporation owners–a drop to almost zero–the vast majority of producers and clients agree.

Executive Bonus/Section 162 Plan for C corporation Owners

What are we left with? See Table 1 for the C corporation income tax rates.

The top individual rates are 33% and 35%. Even if you add the 2.9% Medicare tax, the owner of a C corporation hasn’t much reason to do anything but take additional compensation, assuming the compensation stays within the bounds of reasonableness.

Tax has to be paid, either at the corporate level or the individual level. Maybe the best thing to do is to take additional compensation. Be sure it stays within the bounds of “reasonable” compensation, per Section 162 of the IRC.


The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JAGTRRA) gave us a niche technique: the 15% tax on qualifying dividends. Dividends from a C corporation fit that requirement.

Let’s revisit the owner doing year-end tax planning. What about that last $50,000 of profit? It could be taken as additional compensation.

Allowing for the 35% bracket, plus 2.9% for Medicare tax, there would be $31,050 left from a $50,000 year-end bonus. If we pay corporate income tax on that $50,000, $42,500 will remain. If we use that to pay a dividend, there will be $36,125 left over–an additional $5,075.

You should take the dividend. The situation will change, depending on actual tax rates. It may be best to take some funds as additional compensation and some dividends.

There are some cautions, though. First, the IRS can challenge unreasonably low compensation. Also, the 15% rate expires after 2008.

Owners of Pass-Through Entities

An S corporation owner can be an employee of the corporation. Therefore, many producers think the executive bonus is viable. See Table 2 for a simplified example of the effect a $50,000 year-end bonus has on the owner’s individual taxable income.

As you can see, the year-end bonus generates no tax savings and actually costs money because Medicare tax applies to all wages. The solution is an S corporation distribution.

Since the income already has been taxed at the individual level, there generally will be no additional income tax when the cash is taken. And the vast majority of limited liability companies (LLCs) elect pass-through taxation.

Therefore, LLC members are in the same situation as the S corporation owners. So, they should withdraw the money from their capital accounts.


C corporations: CASD is less advantageous than before because of the reduced tax leverage and because the tax on the imputed interest income is more expensive. And there are real questions about how to dispose of the accumulated shareholder loans when the plan is terminated.

Dividends may be a good alternative, but they should be analyzed carefully. Other than dividends, additional compensation appears to be the most efficient approach.

Pass-Through Entities: Here, it’s simple. Generally, 100% owners of the S corporation should take S corporation distributions; and, LLC members should take withdrawals for members’ capital accounts.

The big lesson: keep it simple

The primary goal is to get money out of the business to save for retirement, but it’s important to do so in the most tax-efficient manner:

o Additional compensation for C corporation owners, maybe dividends, depending on tax rates;

o S corporation distributions for S corporation owners; and

o Capital withdrawals for LLC members.

The lesson of this broad overview of a complex planning area is that the simplest techniques are probably now the best. But when examining all of the options, it is important to consult with a professional tax and/or legal professional for all the answers to your questions.

David K. Smucker, CPA, CLU, CFP, ChFC, serves as advanced sales consultant for Nationwide Financial in Columbus, Ohio. He can be reached at [email protected]