Benefits Planning

Finding trustworthy, productive employees and keeping them motivated is one of the biggest challenge facing business owners.  Wage and salary compensation is certainly a leading component of employee satisfaction, but a competitive benefits package can be a motivating force as well. 

Another challenge is recruiting new employees to a small business, especially targeted individuals who are working in a corporation and are accustomed to having a plump benefit package.

Whether the benefits are employer-provided group health insurance, a company-sponsored retirement plan or voluntary benefits available for purchase by the employee, the business owner should design a comprehensive benefits package that balances the benefits with the cost shared between owner and employee.

Good employee benefits planning start with a conversation with key employees to gain an understanding of the benefits they most value.  Market research can uncover the benefits package offered by competitors as a benchmark to your company's current benefits program.  Lastly, consider the numerous income tax advantages available to business owners offering various benefits in qualified employee benefit plans.

There are a number of planning advantages associated with employee benefit planning and a number of ways to legally enrich the business owner/family disproportionately to the rank and file employees.


Like their larger counterparts, a small business can offer tax-deductible retirement plan benefits to their employees affordably using streamlined retirement plans created especially for the small business employer.

The two most common plans – SEP IRA and SIMPLE IRA – are simplified versions of defined contribution plans – profit sharing and 401(k) plans - offered by larger employers.

Each plan is self-managed by the employer – no third-party administrator is required and administrative time/cost is low.  The plans work as a loose confederation of employee IRA accounts in which the employer has the responsibility to include all eligible employees in the plan, make plan contributions on a timely basis and to refrain from discriminating in favor of the business owner or key employees. 

A SEP-IRA is for intents a purposes a profit-sharing plan:  Contributions by the employer are discretionary up to 25% of the employee's compensation with no vesting restrictions.  The employer can contribute 20% of W2 or business income into the SEP IRA and take a tax deduction. 

Contributions to a SEP IRA are only allowed by the employer and the employee can take an immediate withdrawal of the contribution, but it would be subject to taxation and penalties if under age 59.5. 

Similar to a 401(k) plan, contributions to a SIMPLE IRA plan are a tandem arrangement between employer and employee.  The employer has a responsibility to fully match the employee's elective deferral of wages of up to 3% with immediate vesting, immediate availability to the employee and any employee withdrawal subject to taxation and penalties if under age 59.5.  The employer is allowed to fully participate in the plan up to the statutory annual contribution limits.

Profit Share Plan

One of most useful tax and retirement planning tools available to business owners is a profit share plan.  One of the key benefits is employee motivation - they can share in the financial success of the business by receiving some of the profits tax-deferred and allocate to their own qualified retirement account.

The owner has the discretion each year whether to fund a profit share contribution - there are no mandatory funding obligations.  The profit share contribution works like a tax-deferred bonus to the employee yet is fully deductible in the year of contribution to the employer.

There are a number of profit share calculation methods to legally maximize the owner's share of the profit share contribution.  In addition, the owner can institute a vesting schedule for up to six years for profit sharing allocations to reward employees for loyalty and service. 

Unlike a SEP IRA, the employees cannot withdraw their vested profit-share assets until they separate from service.

401(k) Plan

A 401(k) plan is actually a component of a profit-sharing retirement plan.  It has become the primary retirement benefit plan for many corporate employees and it entails material administration and record-keeping requirements for the employer to meet federal labor (ERISA) and tax (IRS) regulations.

The employee participation in a 401(k) plan is the voluntary deferral of compensation each pay period.  The employer can elect to match the employee deferral or add a profit-sharing or non-elective contribution on behalf of each employee, all at their discretion and often subject to a vesting period. 

The maximum amount that can be contributed to the 401(k) plan by the employer and employee each year is limited by tax law and discrimination tests.

There are income tax benefits to the employer and employee when an employee participates in the 401(k) plan through elective deferrals.  Distributions from the 401(k) are typically not allowed until the employee terminates employment. 

Depending on the specific plan rules, a participant can borrow from their 401(k) plan under strict repayment terms.  In addition, many 401(k) plans are adding a Roth (401) provision, which allows much higher contributions to a Roth account without the income and contribution ceilings of a Roth IRA.

403(b) Plan

Also referred to as a tax-sheltered annuity ("TSA"), the 403(b) plan is similar to a 401(k) plan and is offered to public school teachers and employees of not-for-profit organizations.

Like the 401(k), each employer determines the benefits of the 403(b) plan, including employer matching contributions, which along with employee salary reductions, are subject to maximums set by tax law.

Similar to a 401(k), the 403(b) participant often can borrow from their plan with strict repayment terms, is penalized for withdrawals before age 55 and must take minimum distributions the year after which they turn age 70.5.  Some 403(b) plans allow penalty free distributions into other tax-qualified plans.

Most employers approve a list of annuity and/or mutual fund investment produces offered by various investment companies for the employees to choose from.

Defined Benefit Plan

A defined benefit plan is the traditional pension plan that past generations of retirees relied on as their primary retirement asset.  The employer contributes dollars into a pension pool on behalf of the employee, with the future benefit based on a formula combining the employee's compensation, years of service and a target retirement age. 

Defined benefit plans are expensive to administer, are subject to strict pension/tax laws and requires funding of the plan each year.  Consequently, many employers have terminated these plans and replaced them with defined contribution plans like a 401(k) plan.   Moreover, some  pension plans are seriously under-funded, placing the retiree's future pension benefits at risk.

Selecting the right employee pension benefit option at retirement is an important planning decision.  It is irrevocable and it should take into consideration any spouse survivor needs.  Some pension plans offer a lump-sum payout over a life annuity at retirement and the lump sum could be the better alternative depending on your situation and the actuarial health of the pension plan.

For high-income professionals with few/zero employees, a fully insured 412(e)3 pension plan is a special defined benefit pension plan that can serve as an attractive retirement and tax savings strategy.  The plan can only invest in life insurance and fixed annuities and must be funded for a number of years to satisfy tax law requirements.

Deferred Compensation Plan

A non-qualified deferred compensation plan can be an effective compensation planning tool for business owners to reward key employees and themselves.

Two important requirements must be met for non-qualified deferred compensation to qualify for income tax deferral.  First, the employee must formally elect to defer the compensation before services are performed and the income earned.  The employee defers the earned income until the earlier of retirement or separation from employment.

The employee has the unfettered right to take their deferred income at their discretion in the future, at which time it will be taxed as earned income and the employer can take a corresponding business expense deduction.

Secondly, there must be a substantial risk of forfeiture of the deferred income to the employee; there cannot be a guarantee or certainty of payment.  If the deferred comp plan is unfunded by the employer, then by definition no employee income is recognized until received.  If the plan is funded, then the employee's right to receive or transfer deferred income cannot be guaranteed or it is considered constructively received and taxable.

The plan should be geared towards highly compensation employees to steer clear of federal pension regulation of the plan and allow discrimination of plan benefits in favor of the owner and key employees.

If the employer wants to informally fund the plan to reserve for future employee cash payouts, cash value life insurance is often the best investment choice since earning/growth inside the insurance policy would not be taxed to the employer during the deferral phase.

Section 125 Plan

Also known as a "cafeteria plan" and a "flexible spending plan", a 125 plan is a cost-effective way for a business owner to offer more voluntary employee benefits on a tax-advantaged basis.  

The 125 is a qualified employee benefit plan that must offer two or more benefits. Common examples of benefits included in a 125 plan are the employee's share of group health insurance premiums, term life insurance, vision/dental care, accident/disability insurance, and dependent care expenses.

Employee salary reductions run through the 125 plan and reduce the employee's taxable income; the employee nor employer incurs payroll tax on employee contributions.  This is called a Premium Only Plan ("POP") and it is an effective way to lower the tax impact of the employee's share of health insurance premiums and to allow them to select their desired voluntary benefits they want  on a tax-efficient basis as well.

The Flexible Spending Account ("FSA") is a more complicated  125 plan.  Each plan year the employee earmarks a portion of expected wage income to be withheld each pay period to fund their individual FSA account.  Funds are withdrawn by the employee to pay for eligible medical, transportation and dependent care expenses.  However, the plan's use-it-or-lose rules require that all FSA funds be expended each plan year or they are forfeited to the employer.

Per tax law, a 125 plan cannot discriminate in favor of the business owner and a Sub S owner/spouse, partners and self-employed owners cannot participate in the plan