Establishing a defined-benefit plan to maximize contributions for older shareholder-employees.

• Author: Ellentuck, Albert B.

A defined-benefit (DB) pension plan is designed to provide a definitely determinable annual retirement benefit in the form of a pension. The benefit is calculated using the plan s benefit formula and must be funded during the employee's working years. The computation of the annual contribution needed to provide this benefit requires complex actuarial calculations. This annual contribution becomes a fixed obligation, funded without regard to the employer's financial condition.

Ideal Scenario

Establishing a DB plan is most advantageous for a corporation with stable or growing earnings and shareholder-employees age 50 and older with long service records. The corporation should have the financial resources to meet the DB plan's funding requirements for at least five (preferably, 10) years, to avoid IRS arguments that the plan was not intended to be permanent when adopted.

Advantages

The advantages of a DB plan are:

1. The employer generates current tax savings, while accumulating retirement benefits primarily for the owners.

2. Shareholder-employees avoid current taxation on the benefits being funded for them.

3. Shareholder-employees' account balances will increase dramatically over a relatively short period, due to large employer contributions and tax-deferred earnings thereon.

Disadvantages

There are some significant disadvantages to DB plans. The administrative costs can be significantly higher than those for other plan types, due to the requirement to obtain actuarial services annually. Also, the employer will bear the burden of any investment losses, in the form of increased funding requirements.

Because a DB plan guarantees a certain benefit, investment losses will require larger contributions to maintain those benefits. Of course, investment gains will reduce the employer's funding requirements.

Example

David, Mark and John own Boxcorp, a calendar-year C corporation. Over the past five years, sales have doubled and net profits have tripled. The owners want to maximize their accumulation of retirement dollars and the corporation's deductions, because Boxcorp is in the 34% bracket. The following summarizes pertinent information for the three shareholder-employees:

Mark John Age 55 56 55 Past service (years) 8 9 10 Compensation $225,000 $225,000 $225,000 In...