Sub-Chapter S Corporation: The Retirement Plan & Tax Deferred Benefits
In theory, a dollar today is worth more than a dollar tomorrow. According to the time value of money, a dollar today has the ability to earn a return, typically interest, and compound over time. Retirement plans that allow employees and owners to defer income, and consequently tax, provide the same benefit. Deferring taxes keeps more money in your pocket today (and this tax year). Deferred income becomes taxable after distribution from the retirement plan. Knowing the retirement plans available and understanding their benefits can increase the value of an s-corporation's income.
Simplified Employee Pension Plans (SEP Plans)
Simplified employee pension plans, or SEP plans, provide s-corporation employees the ability to defer income through a qualified retirement plan. Contrary to other retirement plans, employees do not make contributions to SEPs. All contributions are made by the business and must adhere to a written allocation formula. Plan contributions must not favor highly paid employees. According to the IRS, the maximum contribution employers can make to each employee is the the lesser of $49,000 or 25 percent of the each respective employee’s total compensation.
Simple IRA plans allow contributions from both the employer and employees. The IRS limits employee contributions to $11,500 and employer contributions to up to three percent of an employee’s salary. Employees receive deferred income and the s-corporation receives a retirement plan deduction for qualified contributions made for employees. Employees over 50 are able to make an additional $2,500 catch-up contribution per year. Small businesses commonly use trustees to manage retirement plan funds.
Defined benefit plans such as 401Ks allow employees to contribute up to $16,500 annually, and $22,000 for employees age 50 and over. The IRS limits employer contributions to three percent. To qualify for tax benefits, plans must not discriminate in the allocation of matching employer contributions. Small businesses commonly hire a retirement plan administrator to set up new plans. Employees can acquire loans against their respective retirement accounts. The IRS provides a small business booklet with additional details on the formation, rules and regulations surrounding 401(K) plans.
Employee stock ownership plans (ESOP) provide an s-corporation the ability to shelter tax profits in a retirement plan. Unless there is a sale of stock, annual contributions become deferred income. The IRS requires that distributions from the corporation's retained earnings be made in accordance to ownership, therefore the ESOP is required to receive distributions if other shareholders take distributions. ESOPs with larger ownership shares may receive more benefits than was originally intended because of distributions.
The IRS allows s-corporations to offer retirement plans designed to defer income to employees. Of course, owners are most often interested in these plans, although rules prohibit discrimination in order to qualify for tax deductions. Annual limitations are subject to change. The IRS may change limits and other rules annually, so be wary of your current limitations before contributing and setting up employee payroll contributions. For questions on annual limits, consult an enrolled agent, a tax professional licensed by the Department of the Treasury.
Jeremy Slaughter began writing business and hobby articles in 2009 after completing his master's degree in accounting at the Keller Graduate School of Management. As a tax, accounting and small business expert, Slaughter co-founded an accounting and tax firm where writing plays a daily role.