S Corp establishing a DB plan for corporate owners to avoid capital ga

[KJohnson]

An S Corp. that has sold all of its assets and no longer has any employees except for the owner and his wife (ages 60 and 55). The corporation has been approached about setting up a DB Plan for its owners and funding it in the year of the sale to avoid c.g. tax on the sale. Thee owners are planning on looking into other ventures for the corporation, but have no definite plans at the moment. The owners plan to work only for a few more years in any event. I have a number of questions on whether this can work. Among these are:

1) The permanency and subterfuge provisions in 1.401(1)(B)(2) and (3),

2) Whether an S Corp. can offset an ordinary expese against capital gains?

3) Whether there is a method to fund the DB entirely in a single year and still take the deduction?

4) The effect of the phase in of the $130,000 Section 415 limit based on years of participation?

5) The general advisability of converting c.g. into ordinary income through use of a pension plan.

Any thoughts, articles or cites would be appreciated.

[Lorraine Dorsa]

I can comment on pension issues, but not tax issues.

1. Permanency is an issue, but I've put in many plans which only last for a few years due to the retirement of the principal(s) and the subsequent dissolution of the company/firm/practice and had no objection from the IRS upon termination.

1a. There is also another issue to consider--non-discrimination under IRC 1.401(a)(4)-5 re timing of plan amendments with the effect of significantly discriminating in favor of HCEs. Example 1 of this section refers to a DB plan which has its benefit increased after all employees other than the HCEs have been terminated. I think you can avoid this issue with proper plan design (providing benefits only for service after the change in the company), but it needs to be considered.

3. Defined benefit plans must be funded using a reasonable funding method and following IRC 412 re minimum funding standards and IRC 404 re deductions, the practical result of which is that the plan must be funded over its lifetime. If a large amount is deposited the first year as you propose, the amount over the maximum deductible amount of IRC 404 is not only not deductible but subject to a 10% excise tax. And if it cannot be deducted in the following year, the excess over the deductible amount in that year is again subject to another 10% excise tax (and on and on for future years until the entire amount can be deducted).

4. The 415 $ limit is reduced prorata for years of participation less than 10, so if the principals will have only 5 years of participation at retirement, the limit is 5/10 of $135,000 (= limit indexed to 2000). However, benefits and contributions for older participants can still be significant so don't let this stop you from adopting the plan.

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