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2013 Tax Options For The Small Business Owner

Updated on November 9, 2012

Income Tax Deferral

As the 2012 elections are completed, it is now highly likely that income taxes are headed higher on higher earners. A majority of such high earners are self-employed individuals who are organized as either S-Corps, LLC’s and even sole proprietors. The good news for most of those that are self-employed, is that there are options. In the late 70’s many financial institutions made a very good living by selling tax shelters to wealthy individuals. Should rates rise accordingly, we may see this again. However, for now let’s look at some of the current options. Most small business owners already have some form of a retirement plan established for themselves. Yet as per ERISA laws, a qualified retirement plan requires that the each full time employee be included if they fall into the parameters of the benefits testing. This can mean a substantial cost to each employer in employee matching contributions. So how can we defer income, and protect ourselves from the potential liability ??? There are a few options available to us.

In many cases financial advisers will push the benefits of non-qualified tax deferred annuities. In some cases they may make sense. Yet deferred annuities only defer the earnings, not the taxable income from employment.

Non-Qualified Deferred Compensation Plans (NQDC)

These plans are available to both small and large business entities. They fall under the Internal Revenue Code 409A, yet do not have to meet all of the ERISA requirements. Simply stated, you may be able defer your income from income taxes without contributing on behalf of your employee’s. Clearly if you are someone who doesn’t have a lot of discretionary income, then you’ll not likely benefit from such a strategy. As such, the income taxes increases that are likely to develop won’t impact you. However, if you happen to be someone who has the sizeable discretionary income to maximize their 401k/IRA and Pension Plans with cash flow left over, this may be to your benefit.

Under a NQDC plan you can defer your own salary, bonus and other forms of compensation until such time as tax rates make it more favorable to realize such income.

There are two basic types of plans. The Elective Deferral & The Supplemental Benefit Plans

Elective Deferral

Under this approach, the employee elects to defer a portion of their compensation in a written agreement until a specific date. This may be retirement, or termination from employment. Since most self-employed individuals draw a salary from their business, this makes them eligible to defer income.

Supplemental Benefits Plans

Under this type of plan the employer makes the legally binding agreement to contribute on behalf of the employee, usually payable at retirement. This becomes more of future business deduction for the self-employed individual rather than a salary deferral for the purpose of deferring income that would otherwise be taxed as a pass through profit on the employers K1. However, under this type of plan, the business does not receive the business deduction until the employee actually realizes the income. So for small business owners, this is less common.

Under the doctrine of “constructive receipt” an individual is taxed on income when it is actually made available to him. So the benefit of this type of plan is the owner defers income and essentially makes the cash flow temporarily unavailable to him, and as such reduces their tax liability until a more favorable tax environment exists. Because of the fact that the income is unavailable to the employee, the plan is effectively an asset of the company. This makes the employee an unsecured creditor of the employer until retirement. Yet again, for small business owners the employer and employee are one in the same. The fact that the plan is considered an asset of the employer, it is subject to all creditors in the event of a bankruptcy or some form of litigation. So for individuals who may have a business in distress, this should be considered before drafting such a plan.

How do you create such a plan ???

Drafting a plan typically requires either retaining the services of a Third Party Administrator (TPA) or having in house actuaries if a broker dealer or insurance company to draft one. They would charge a fee to draft the initial plan document as well as a fee to make any plan amendments. Once the plan document is created, the business owner can then open the account under the plan name and begin funding contributions. Investment options in the plan are typically limited to public traded securities such as stocks bonds, mutual funds and cash equivalents.

Deferral

Plans are typically deferred until the employee’s termination date. For those who are self employed, that would typically mean retirement. Upon such a date, depending on how the plan is written, the distributions are made over a 5 year period, 10 year period or in one lump sum. For most individual plans, the 10 year payout option is best as is continues to spread out the tax liability over time and keep the effective tax rate lower.

Who is eligible ???

One of the biggest benefits to the small business owner is that because the NQDC plan has fewer requirements, it is more flexible that qualified plans under ERISA. One such rule that is not observed is the non-discrimination testing. This means that the plan can be offered to a select group of employees. So for example, perhaps it is made available to only the Vice Presidents of the company. However, if you serve as the President and Vice President of your company, and none of your hypothetical 20 employees hold this title, you are the only one eligible to participate.

Each individual small business owner should consider carefully their options and consult with a professional before implementing such a plan to see if it suits their business demographics. The NQDC plan is just one option available. In many cases there may be a more suitable approach. Just because tax rates are likely to go up doesn’t mean you should rush to judgment. Take your time to review your options and make an educated decision.


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    • LandmarkWealth profile image
      Author

      LandmarkWealth 5 years ago from Melville NY

      I would disagree about the integrity part. Most employers will offer a qualified plan or a simple/SEP plan with the Non-qual plan in addition should they have the cash flow. The problem is small business owners often have too many transient people. So they usually create a plan that minimizes their contributions anyway, as does the Simple with the max 3% match. And as you mentioned. Most employees are too foolish to participate anyway.

    • My Esoteric profile image

      My Esoteric 5 years ago from Keystone Heights, FL

      Very useful indeed and something I need to consider. Having said that, it is my position that no business owner with any integrety would offer a retirement plan for him or herself without having something, maybe not the same thing, for their employees. For my company, we offer the SIMPLE IRA, although few, unfortunately, take advantage of it.