Tax doesn't have to be taxing
As minimum wages rise in many states and employers look to increase benefits without raising salaries, many carwash operators are considering 401(k) and health insurance plans for their management employees. But did you know that government officials now expect 401(k) plan sponsors (i.e., the employer) to conduct periodic due diligence reviews?
And did you know the IRS is substantially increasing its audits of small businesses? Or that a welfare benefit plan can make your estate, business succession, or buy-sell plan tax deductible? You can even have a welfare benefit plan in addition to a retirement plan.
Not only that, but medical expenses reimbursed to employees are tax deductible for the business and tax-free for the employees. Do you pay too much income tax? Sound interesting? Read on.
IRS secrets you should know
Today, the IRS is conducting more audits of small businesses, focusing on non-compliance with employment tax rules. Auditors are looking for inappropriate transactions and questionable reporting. Some other audit targets are S corporations that pay shareholders low salaries while paying out the majority of profits as pass through distributions, thus avoiding payroll tax.
Over the past few years, the IRS has dramatically stepped up its efforts to study specific industries, and to educate its examiners about business practices, terminology, accounting methods, and common industry practices. It has also identified areas of inquiry that produce audit results. Examiners are told specifically to look for certain red flags to get at what is really going on in a business or transaction.
The result is that examinations are more sharply focused on potential areas that will generate increased taxes, penalties, and interest. Fortunately, there is a positive side to all of this. The IRS has made public a number of its Industry Specialization Program papers and Market Segment Specialization program manuals. These help us keep up on the areas that the IRS will be targeting in its audits. So far, it has issued detailed audit guide information on a range of industries.
Survive an audit
A review of your business practices, with a view toward making some changes in light of the new IRS audit and compliance initiatives, may help keep your returns from being selected for examination, or help you survive if you return is audited.
This year and next, IRS audits of small companies will substantially increase. The IRS will also expand its audit program for retirement plans, another possible reason why the IRS may visit you. Small business owners are at risk here because most don’t have qualified advisors for their retirement plans. If the retirement plan has any faults, the penalties could be severe. Most errors are general. The attorney or accountant who handles the plan may not be an expert. Most of the retirement plans that we have reviewed for potential clients were flawed. So get a competent advisor to review your plan before the IRS does.
Avoiding the watchful eye
There may be an alternative — something that, since it is not technically a retirement plan, will escape this heightened scrutiny of retirement plans.
Do you have a welfare benefit plan? The contribution is tax deductible, and money can come out tax free for certain benefits, even before retirement. The money in the plan is free from the claims of creditors.
A welfare benefit plan can make your estate, business succession, or buy-sell plan tax deductible. You can even have a welfare benefit plan in addition to a retirement plan. The plan can even make life insurance deductible. But you need to be careful because if the plan is set up improperly you could get into trouble.
Are you interested in reducing your company’s health care premium by 60 percent? How about saving on income taxes while investing money for the future to be used tax-free? If so, then you’ll be interested in a health reimbursement arrangement plus (HRA-Plus).
The HRA-Plus can reimburse employees, including owners, for a predetermined amount of medical expenses. It provides the best premium savings when established in conjunction with a high deductible health insurance plan. Medical expenses reimbursed to employees are tax deductible for the business and tax-free for the employees. There is no need to pre-fund the HRA-Plus, and the employer can keep the funds if an employee terminates.
Substantial tax reduction, estate planning, and asset protection — Welfare Benefit Plan (WBP) anyone? Do you pay too much income tax? Are you interested in protecting your assets from creditors? Would you like incredibly large tax deductions every year? How about providing financial security for your family while minimizing taxes? Sound interesting? If so, you should consider a WBP. All contributions are tax deductible, and the money withdrawn for certain benefits is tax-free. Profitable businesses looking to substantially reduce their tax liabilities and provide other benefits can utilize a WBP. Although they have been in existence for years, WBPs are not widely known or well understood. They allow an employer to receive a current tax deduction while putting away funds not currently needed. They also give an employer a great deal of latitude in choosing both present and future plan benefits.
Additional benefits of WBPs include the protection of assets from creditors, tremendous flexibility in establishing contribution amounts, and highly favorable monetary benefits for the business owner. Also, a plan can allow you to deduct life, health, disability and long-term care insurance premiums and solve retained earnings problems. An employer can have a retirement plan and a WBP simultaneously. A WBP allows for larger tax deductible contributions than a 401(k) plan because it is not subject to strict pension plan guidelines.
The problem with a retirement plan is that, live or die, when the money comes out, it’s taxable. Who says you will be in a lower tax bracket when you retire? When you die, not only will your retirement plan money be subject to income tax, but if you are successful, the money will also be subject to estate taxes. Money in a WBP can be withdrawn both income and estate tax-free. It’s never too early or too late for successful business owners to consider these things.
You do need to be careful, however. Numerous plans look like WBPs but do not meet the well-established and specific guidelines of the Internal Revenue Service (IRS). Treating a look-alike plan as though it were a true WBP can get you into serious trouble with the IRS.
Has your 401k or other retirement plan been reviewed?
Government officials now expect 401(k) plan sponsors to conduct periodic due diligence reviews. With respect to their 401k or other retirement plans, the problem is that most sponsors (owners) do not have the in-house resources to do so.
This is not something that 401(k) plans historically did. On the heels of the recent mutual fund scandals, though, U.S. Labor Department officials have indicated sponsors have a duty to periodically investigate plans and benchmark funds and fees.
Baby boomers are now retiring, and their 401(k) accounts often are their primary source of retirement income. A sponsor potentially could be liable for less than stellar 401(k) account growth if employees can claim that he did not meet his fiduciary duties.
Trusting the reputation of a major mutual fund company is not enough anymore.
Sponsors must investigate and compare their plans to other programs at least every two to five years, as well as demonstrate that their plan expenses are in line with what others are paying.
Blind trust is not prudent. You need a process, and you need to document that process.
Every fiduciary decision has to be made through a careful process. According to ERISA, the primary plan fiduciary is the sponsor, i.e., the employer.
Therefore, it is the employer’s responsibility to ensure the prudent selection and oversight of plan vendors.
Sponsors must monitor vendors in two ways:
- Micromonitoring, which should occur annually, examines plan features and services; and
- Macromonitoring occurs every three years or so and allows sponsors to benchmark with competitors.
Smaller employers who comparatively lack resources and manpower find it difficult to monitor vendors to this extent. Thus, owing to ERISA provisions that compel bewildered sponsors to take on experts to help with due diligence, most small to mid sized plans will need to hire consultants.
There is potential liability if due diligence reviews are not conducted. Failure to engage in a prudent process may breach fiduciary duties, which may render the sponsor liable for damages.
For example, if plan participants pay fees that are higher than the current market rate because the sponsor did not perform a review, that fiduciary could be liable for the higher fees.
But as long as the sponsor can prove he did a proper investigation, he can potentially shield himself from liability.
The employer has to show that he engaged in a prudent process and that he made a reasonable decision based on that process. This applies to all retirement plans, not only 401(k) plans.
Lance Wallach, CLU, ChFC, CIMC of Plainview, New York, speaks and writes extensively about VEBAs, retirement plans, and tax reduction strategies. For more information, email Lance at: LAWallach@aol.com, call (516) 938-5007 or visit www.vebaplan.com. The information provided herein is not intended as legal, accounting, financial, or any other type of advice for any specific individual or other entity. You should contact an appropriate professional for any such advice.