1975, January, Pg. 1. H.R. 10 Plans.

• Author: by Bruce Moore

4 Colo.Law. 1

Colorado Lawyer

1975.

1975, January, Pg. 1.

H.R. 10 Plans

1Vol. 4, No. 1, Pg. 1H.R. 10 Plansby Bruce MooreAlthough significant changes have been made in the H.R. 10 plan, the self-employed qualified plan has not yet attained equal status with its corporate brethren. The changes in H.R. 10 plans brought about by the Employee Retirement Income Security Act of 1974 (the Act) will cause the self-employed person to examine more closely the economics of the self-employed qualified plan before incorporating to obtain the benefits of a retirement plan. This article describes the changes made by the Act to the H.R. 10 plan and to the qualified plan covering shareholder-employees. In general, several of the more significant changes made by the Act to the qualified plan covering an owner-employee(fn1) are applicable to plans covering nonowner-employees and subchapter S shareholder-employees.(fn2) There are, however, important distinctions between the changes made by the Act with respect to the latter two types of plans and the plan covering an owner-employee.

Prior Law RetainedSome major items remain unchanged by the Act. Initially, an H.R. 10 plan must cover all employees who have at least three years of service.(fn3) Service for this purpose will be determined by reference to the new service rules applicable to all plans qualified under the Internal Revenue Code. An employee's rights to contributions made on his behalf are non-forfeitable when made.(fn4) May the employer fund his contributions to the plan with property other than cash?(fn5) An owner-employee must consent to be covered under the plan,(fn6) and integration with Social Security is prohibited for a plan under which more than one-third of the employer contributions will benefit owner-employees.(fn7) The estate tax exclusion for plan benefits attributable to employer contributions is not available to the self-employed person.(fn8) The entire plan interest of the self-employed person must be distributed to him not later than his taxable year in which he attains age 70 1/2 or, for the nonowner-employee, his taxable year of retirement, if later.(fn9)

Contribution LimitationFor the H.R. 10 plan, the most important change made by the Act is the increased contribution limitation. For taxable years commencing after December 31, 1973,(fn10) the self-employed person may contribute to an H.R. 10 plan an amount not exceeding $7,500 or 15 percent of the first $100,000(fn11) of earned income derived by the self-employed person from the trade or business for which the plan is established.(fn12) In a taxable year in which the self-employed person's applicable earned income is less than $5,000, the Act softens

2the 15 percent limitation and permits a contribution equal to the lesser of $750 or 100 percent of such earned income.(fn13) The "first $100,000 of earned income" provision effectively sets at 7 1/2 percent the lowest variable formula percentage for a self-employed person earning $100,000 or more who wishes to make the maximum contribution for himself. If an H.R. 10 plan qualified under pre-Act law is amended prior to December 31, 1975, solely to take advantage of the increased deduction limitation, it is presently not necessary to request a determination letter,(fn14) although it may be advisable to provide the District Director of the Internal Revenue Service with a copy of the change.The $7,500-15 percent maximum and the $750-100 percent minimum contribution limitations are applied in the aggregate if contributions are made on behalf of the self-employed person under two or more plans.(fn15) Furthermore, contributions allocable to certain types of insurance are not taken into account in applying contribution limitations.(fn16) This latter provision permits a contribution to be made in excess of the deductible limits if the excess is allocable solely to insurance "protection."

Premature DistributionsUnder prior law, a distribution from a self-employed plan to the non-disabled owner-employee prior to his attaining age 59 1/2 resulted in a 10 percent increase in the tax attributable to the premature distribution. Further, the employer could not make a contribution to the plan on behalf of the distributee owner-employee for the five-year period following the taxable year of premature distribution. The Act retains this latter proscription, and in addition, for taxable years commencing after December 31, 1975, increases the penalty tax on the premature distribution to 10 percent of the distribution itself.(fn17) Under the Act, a premature distribution placed in a marginal bracket of 25 percent would result in a penalty tax four times greater than under prior law.

Voluntary ContributionsThe self-employed owner-employee is prohibited from making a voluntary contribution to his H.R. 10 plan if only owner-employees are covered under the plan.(fn18) Furthermore, the maximum voluntary contribution the owner-employee may make in any taxable year on his own behalf remains the lesser of $2,500 or 10 percent of the applicable earned income, not to exceed, however, the rate at which employees other than owner-employees are permitted to make voluntary contributions.(fn19)

Under prior law, a non-disabled owner-employee was not permitted to withdraw his voluntary contribution prior to his attaining age 59 1/2 without incurring a tax on a premature distribution. For taxable years ending after September 2, 1974, a plan may permit the owner-employee to withdraw his voluntary contributions without penalty.(fn20)

Tax on Excess ContributionsUnder prior law, a willful excess contribution barred the self-employed person from participating in the plan for a five-year period. For taxable years commencing after December 31, 1975, the Act replaces this provision with a 6 percent cumulative excise tax on the amount of the excess contributions.(fn21) The amount of excess contribution is determined as of the close of each taxable year. In general, an excess contribution is a contribution which exceeds the sum of the deduction limitations discussed above plus (in the case of an owner-employee) the allowable voluntary contribution amount.(fn22) In the case of a defined benefit plan, the excess contribution provision will not apply until the plan is fully funded at the close of the employer's taxable year.(fn23)

The running of the tax on the excess contribution can be stopped for a particular taxable year by repaying the excess amount on the last day of that year or by applying the excess amount to the allowable employer contribution for that year.(fn24) In the latter instance, the excess amount would be deductible for the taxable

3year in which applied. The tax on excess contributions applies without regard to mistakes in the calculation of the allowable contribution and there is no provision for abatement.Minimum Funding--- The Variable FormulaA money purchase H.R. 10 plan is subject to the new minimum funding standard and the new tax(fn25) on an accumulated deficiency, whereas a profit sharing plan is specifically excepted from funding requirements.(fn26) In brief, an accumulated deficiency is an excess of plan charges over plan credits.(fn27) An accumulated deficiency would be present under an H.R. 10 money purchase plan if for a particular year the employer failed to make the full contribution stated in the plan. Under H.R. 10, the difference between a money purchase pension plan and a profit sharing plan is slight. If the formula for contributions to the plan on behalf of the common law employees is expressed in terms of a percentage of compensation without regard to the rate of contribution for the self-employed person, the plan is considered a money purchase pension plan.(fn28) If this formula is expressed in terms of a varying percentage of compensation which is in the same proportion that the contribution for the self-employed person bears to his applicable earned income, the plan is a profit sharing plan. For the self-employed person with earned income over $50,000 who wishes to make the maximum deductible contribution to his plan, the profit sharing formula will afford him the maximum economy in contributions for his common law employees. Moreover, the profit sharing plan may avoid the tax on an accumulated deficiency for a taxable year in which the self-employed person fails to make a full contribution to the plan.

Defined Benefit PlanFor taxable years commencing after December 31, 1975, the Act permits the self-employed person to establish a defined...