Exploiting IRC Subparagraphs 3121(a)(5)(A) and 3306(a)(5)(A)

[Guest Brian Theismann]

As an IRS agent specializing in employee plans, I am puzzled by the failure of employers to lower their payroll excise taxes by compensating employees through 401(a) plans. I am also mystified by the failure of advisors to notify employers about how profit-sharing contributions avoid excise taxes of as much as 21.3 percent while elective deferrals to the cash-or-deferred arrangement in a 401(k) plan fail to avoid any of that tax (see 3121(v)(1)(A) and 3306®(1)(A)).

A small employer with five employees earning $100,000 in compensation (including deferred compensation) each can defer up to $100,000, thus avoiding $15,300 in Social Security and Medicare excise taxes. The full 21.3 percent (including unemployment), or $21,300, can be avoided if the employees earn no more than $7,000 each. $15,300 seems like a significant tax savings for such a small company, and $21,300 even more so.

When I asked a business-owning friend about this topic he said that his company had a 401(k) plan without profit-sharing contributions because he thought they needed big profits to make such contributions. Of course, such is not the case- the requirement that profit-sharing plan contributions be limited to profits was abolished by statute in the 1980s. Saying that an employer cannot afford such deferrals makes no sense either, because profit-sharing contributions allow employees to keep a greater proportion of their compensation.

Of course, contributions to retirement plans are generally subject to the additional tax on early distributions. However, even if employees cash out all of the contributions, the tax of ten percent is less than the tax savings of 15.3 percent or 21.3 percent. Keep in mind that employer contributions to profit-sharing plans can be distributed at a certain age and that the age at which such distributions are allowed can be less than the age of each and every one of the employees. Revenue

Procedure 80-276 includes the following assertion. "...a profit-sharing plan may specify any age for distribution of

benefits..."

Use of profit-sharing plans for excise tax avoidance may limit the extent to which highly-compensated employees can exploit the benefits of tax deferral. However, I strongly question whether those benefits can realistically be expected to be greater than the value of excise tax avoidance. To begin with, the ADP test can substantially limit the amount highly-compensated employees can defer. Even if they can defer up to the 402(g) limit, the amount is still not very impressive. For example, if all five employees in the example employer cited above deferred the full $16,000 (my apologies if I am a little off) and were in the 31 percent marginal rate in retirement (I am using the rates for married individuals), the savings would only add up to $4,000. And that assumes that they will be earning substantially less during retirement and that tax rates will not go up- both of which are dubious assumptions, for the most part. If the difference in earnings between the time when the compensation is earned and when it is withdrawn does not cross a bracket, no savings will be achieved at all from tax deferral. Moreover, the employer contributions that I discussed above have the very same tax deferral advantages as elective deferrals. In fact, they are even more advantageous, since the total amount of deferred compensation is $100,000 versus only about $80,000 for elective deferrals, as limited by 402(g).

So what am I missing?

[Mike Preston]

In most cases, employees are blissfully unaware of the Social Security taxes (I have a hard time believing they are excise taxes, because excise taxes are not deductible). So, the "savings" to the employee would only by 1/2 of what you describe, and if they are under 59 and 1/2, by pulling the money out they would be in the hole.

But your concept is absolutely correct in theory and many employers who have employees with discretionary income do exactly what you describe.

There is a human element, though, that tends to upset this particular apple cart. Over time, an employee is likely to compare their NET compensation to a job offer. When that happens they will frequently scratch their head and wonder whether they have been woefully underpaid. Of course, they haven't, because they should look to the combination of their take home pay *and* their retirement/profit sharing. But they, at the least, have to be reminded frequently if the employer has implemented a plan that takes that into account.

Also, keep in mind that there is an employer limit of 25% of pay that would also preclude taking too much advantage of this concept.

[Guest Sieve]

Assuming that an employer is appropriately paying his/her employees, why would Mr/Ms Employer contribute even $1 to the PSP account of an employee in order to save 7.65 cents?

If you are suggesting that the employer contribute a significant portion of employees' regular wages into a tax-qualified plan to save FICA, and the employees then take the $$ out immediately to replace their "lost" wages, then I think the IRS would disqualify the plan in a heartbeat as not being a plan of deferrred compensation (since payments would presumably go into the "plan" periodically so that employees could take it out periodically/immediately). (Ses Treas. Reg. Sections 1.401-1(b)(1)(ii): "A profit sharing plan within the meaning of Section 401 is primarily a plan of deferred compensation . . ." and -1(b)(3): "The law is concerned not only with the form of a plan but also its effects in operation.")

[masteff]

We actually looked at "what if instead of an annual raise, we put in a safe harbor plan and put the equivalent of the raise into the plan". One of the biggest problems was unwillingness (on the part of the owners) to commit to it in the long term given uncertainty about future corporate net income levels.

And as the others have said... payroll taxes are paid 1/2 & 1/2 by the ER and the EE. So the savings to the ER are less than stated and in a small enough company can be entirely offset by the cost of plan administration. An additional cost is that of covering NHCEs who the employer might not otherwise normally provide extra compensation.

[Guest Brian Theismann]

I appreciate the thoughts provided in these replies.

What was notable about all the explanations, though, is that none of them provided any rationale for why the benefits of payroll tax avoidance are never touted. For example, a Summary Plan Description that I was reading last week had a small section devoted to the benefits of a money purchase plan. It mentioned tax deferral but not payroll tax avoidance. Why would the prototype sponsor not tell the owners and employees of the plan sponsor about a benefit that they are already receiving as a result of the payments they are making to the prototype sponsor?

[Jim Chad]

Maybe the reason is the fear of the government. Paranoid.....who ME????

I have mentioned it to employers and a few have taken advantage of it and most have made comments about too many employees are more concerned with their paycheck. So the payments to fringes such as health and retirement need to be balanced.

[Bird]

What was notable about all the explanations, though, is that none of them provided any rationale for why the benefits of payroll tax avoidance are never touted. For example, a Summary Plan Description that I was reading last week had a small section devoted to the benefits of a money purchase plan. It mentioned tax deferral but not payroll tax avoidance. Why would the prototype sponsor not tell the owners and employees of the plan sponsor about a benefit that they are already receiving as a result of the payments they are making to the prototype sponsor?

Maybe the reason is the fear of the government. Paranoid.....who ME????

I have mentioned it to employers and a few have taken advantage of it and most have made comments about too many employees are more concerned with their paycheck. So the payments to fringes such as health and retirement need to be balanced.

Exactly. As I see it:

1) We're all trained to put the minimum into official employee communications. Putting anything more in exposes you to comments/criticism/complaints/government action.

2) Nobody reads the SPD anyway, and anyway, most people can't quite comprehend what it means to have 3% or 5% or whatever of pay contributed to a plan. Explaining payroll tax benefits of a retirement plan involves a couple of steps of thought/comparison and will only be met with blank stares.

[movedon]

And, just maybe, employees actually recognize SS as one tax they personally directly benefit from, so maybe they care a little less about avoiding it. OK, probably not.

[masteff]

What was notable about all the explanations, though, is that none of them provided any rationale for why the benefits of payroll tax avoidance are never touted. For example, a Summary Plan Description that I was reading last week had a small section devoted to the benefits of a money purchase plan. It mentioned tax deferral but not payroll tax avoidance. Why would the prototype sponsor not tell the owners and employees of the plan sponsor about a benefit that they are already receiving as a result of the payments they are making to the prototype sponsor?

Telling someone that they would have to pay payroll taxes on this $100 if I gave it to them directly instead of putting it into the plan on their behalf creates the false impression I could choose to simply give them that $100. "Okay, fine, I'll pay the payroll taxes, give me my $100 so I can fix my truck/buy a boat/pay my kid's school tuition." But an employer contribution is not a cash or deferred choice made by the employee. The employee is not an active participant in the choice to avoid the payroll taxes. So it's infinitely better to not misportray that they might have some choice in the matter where they don't.

Tax deferral is relevant to put in an SPD because it is solely by special provision of the Code that the employee does not have to immediately recognize the income.

[Guest Sieve]

I'd don't know if there really is an "exploitation" of the non-applicability of FICA when the distribution is made, as you suggest. But did you ever consider that qualified plans might be an exploitation by the government in touting the tax deferral of these amounts without as loudly reminding people that distributions are taxed as ordinary income and that after-tax investment followed by taxation at capital gains rates might potentially be a better deal for some?

[Guest Brian Theismann]

In most cases, employees are blissfully unaware of the Social Security taxes (I have a hard time believing they are excise taxes, because excise taxes are not deductible). So, the "savings" to the employee would only by 1/2 of what you describe, and if they are under 59 and 1/2, by pulling the money out they would be in the hole.

You are right about payroll taxes not being excise taxes. I am not sure why I started thinking that they were.

Even assuming that the employees cash out all of the contributions to their accounts, the employer can raise their salaries by 2.35 percent to cover the early withdrawal tax and still save 5.3 percent without reducing the employees' after-tax compensation.

There is a human element, though, that tends to upset this particular apple cart. Over time, an employee is likely to compare their NET compensation to a job offer. When that happens they will frequently scratch their head and wonder whether they have been woefully underpaid. Of course, they haven't, because they should look to the combination of their take home pay *and* their retirement/profit sharing. But they, at the least, have to be reminded frequently if the employer has implemented a plan that takes that into account.

That seems like a plausible explanation. What kind of evidence do you have showing that employers are curtailing their use of profit-sharing plans because of this concern? Do employers have evidence showing that employees actually value immediately available cash more than deferred compensation or does that belief result from speculation? Does any research exist on exactly why employees might discount the value of deferred compensation and the magnitude of that discount? Does any research exist on whether employees can be convinced through education that the various benefits of deferred compensation outweigh the flexibility afforded by immediate compensation? I would think that private sector providers would have much to gain from answering those questions.

Also, keep in mind that there is an employer limit of 25% of pay that would also preclude taking too much advantage of this concept.

But, as I showed in my example, the tax benefits can be substantial even for a very small employer. Or are you suggesting that $21,300 per year is not substantial?

[Guest Brian Theismann]

Regarding the issue of whether payroll taxes are excise taxes, the FUTA tax and the employer components of the Social Security and Medicare taxes are excise taxes. See Sections 3111 and 3301. The employee component of FICA seems to be considered an income tax. That seems to make sense.

[Guest Brian Theismann]

Assuming that an employer is appropriately paying his/her employees, why would Mr/Ms Employer contribute even $1 to the PSP account of an employee in order to save 7.65 cents?

I am not sure what you mean by "appropriately paying his/her employees," but the total savings is 15.3 percent in most cases- ignoring 72(t) for a moment. How that percentage is divided is determined by the employer. If the employer decides to take it all, it can lower the part of the employees' compensation that is being redirected into the plan by 7.65 percent. That would enable the employer to save the entire 15.3 percent without lowering the after-tax compensation to the employees.

If the employer decides to give the entire 15.3 percent savings to the employees, it can raise the part of the employees' compensation that is being redirected into the plan by 7.65 percent. The net result would be that the employer's payroll costs would not change but the employees would receive the savings. The employer would benefit because the quantity of its labor supplied would increase, allowing it to retain better employees. That could lead to higher revenues and lower operating costs.

From an economic perspective, it seems likely that that an employer would allocate some of the 15.3 percent savings to employees while keeping some for itself. The 72(t) tax on early withdrawals would tend to argue for giving more of the savings to the employees. However, its significance would depend on the ages of the employees and other factors.

If you are suggesting that the employer contribute a significant portion of employees' regular wages into a tax-qualified plan to save FICA, and the employees then take the $$ out immediately to replace their "lost" wages, then I think the IRS would disqualify the plan in a heartbeat as not being a plan of deferrred compensation (since payments would presumably go into the "plan" periodically so that employees could take it out periodically/immediately). (Ses Treas. Reg. Sections 1.401-1(b)(1)(ii): "A profit sharing plan within the meaning of Section 401 is primarily a plan of deferred compensation . . ." and -1(b)(3): "The law is concerned not only with the form of a plan but also its effects in operation.")

All of the plans that I have audited have had some kind of pre-approval letter. The IRS will not disqualify a plan with a pre-approval letter for complying with the terms of the plan unless the letter explicitly disclaims assurance with regard to the relevant Code Section (or, perhaps, Regulations section). That principle is so well established that I have long since forgotten the authority for that assurance. I will look for it if you would like me to. That leaves two possibilities; either refusal by the IRS to issue assurance for the relevant provision or treating an individually-designed plan without a determination letter as unqualified.

The former would seem to be an untenable position by the IRS. Code Section 401(a)(14) already requires that plans allow certain employees to remove amounts from their accounts immediately upon receipt. There is no operational qualification or limit on that right; if all of the employees take all of the funds in all of their accounts at that point the plan would still not only be in compliance with the law. 26 CFR Section 1.401-1(b)(1)(ii) that you quoted also indicates that the plan can permit participants to take withdrawals upon certain distributable events and places no limit or qualification on that right. If the plan required participants to remove the fund immediately, then the possibility of not obtaining pre-approval seems likely. But if the plan describes itself as primarily a plan of deferred compensation and merely allowed participants to remove amounts upon a distributable event, I highly doubt that anyone in the IRS would view the plan as unqualified in form.

With regard to an audit of an individually-designed plan with a determination letter, the plan would be assessed as qualified in form for the reasons discussed in the previous paragraph. If the plan explicitly allowed removal of funds upon a distributable event and placed no limits on it and someone removed funds immediately, the IRS would not disqualify the plan because the plan administrator was merely complying with the terms of the plan.

[Guest Brian Theismann]

We actually looked at "what if instead of an annual raise, we put in a safe harbor plan and put the equivalent of the raise into the plan". One of the biggest problems was unwillingness (on the part of the owners) to commit to it in the long term given uncertainty about future corporate net income levels.

What do you mean by a "safe harbor plan?" As you may know, there are many safe harbors in the law, so a wide variety of plan types could be described as such. When I hear that phrase, I tend to think of a 401(k)(12) plan, but that tends to defeat the purpose of payroll tax avoidance.

I cannot think of any reason why unprofitable employers would benefit any less from avoiding payroll taxes or be hurt any more by the disadvantages of deferred compensation plans than would profitable employers. Are they being told by providers of plan services about the payroll tax-avoidance advantages provided by 401(a) trusts? Are they being told that contributions to such plans are in no way limited to profits? If not, why not? If they are being told, why do they persist in not taking advantage of profit-sharing plans? Management is not doing its duty of serving the best interests of passive owners if they are forgoing cost savings for irrational reasons.

And as the others have said... payroll taxes are paid 1/2 & 1/2 by the ER and the EE. So the savings to the ER are less than stated and in a small enough company can be entirely offset by the cost of plan administration.

With regard to the half-and-half issue, see my comments above.

With regard to the costs of plan administration, that point would presumably be irrelevant for employers that have existing plans. In fact, plan administration costs would presumably be less for a plan without elective deferrals for two reasons. First, there is less work involved in a plan without deferrals. Second, such a plan can be instituted as a simplified employee pension as defined in 408(p). That type of plan can reasonably be administered by the employer- especially if it is small.

How much do you think the employer in my hypothetical scenario would pay for plan administration?

An additional cost is that of covering NHCEs who the employer might not otherwise normally provide extra compensation.

But again, contributions to a profit-sharing plan do not necessarily need to be in addition to other compensation. An employer could shift some compensation from immediate compensation to deferred compensation. The resulting tax savings could be allocated between employees and employer as seen fit by the employer. Regardless of the allocation, the employer will benefit from the entire savings. That is true because additional compensation for the employees will mean that they will be more resistant to quitting their job.