Many bussiness owners establish qualified pension and profit-sharing plans to increase their personal long-term, tax deferred earnings, and to help the company reduce corporate income taxes. But in its never-ending zeal to dismantle tax shelters, the IRS for years limited the amount of money that could be contributed to these plans annually. Unfortunately, the rules were particularly discriminatory to family businesses.
The rules have changed. Beginning with the 1997 tax year, family members working for the same business will be able to put much more money into qualified savings plans — pension, 401 (k), defined benefit, and certain profit-sharing plans.
A 68 percent increase
The amount of money that can be placed in a qualified plan is determined by federal formulas, which are based on the salaries a company pays to its "highly compensated" employees, typically the owner and a few top executives. But under the old system, the salaries paid to a father, mother, and their minor children working for the same business were lumped together and treated as a single salary. Under this "family aggregation rule," the family was limited to a total of $150,000 in compensation, against which contributions to qualified plans could be taken.
After December 31 of this year, family aggregation will no longer apply. The repeal is part of the recently passed Small Business Job Act; Congress pursued the provision in part because the aggregation rule was so limiting that employers were simply not offering pension plans any more.
The repeal is extremely advantageous for a family business. Consider a family firm that is 100 percent owned by Dad, and pays the following salaries:
| Dad | $150,000 |
| Mom | 50,000 |
| Son, age 18 | 10,000 |
| Daughter, age 17 | 10,000 |
Assume the company has a profit-sharing plan, and that the most that can be set aside in the plan and be exempt from Federal tax is 15 percent of salary. Under family aggregation, Dad's salary alone would have reached the ceiling. Neither Mom nor the two children would be eligible for any funds, since their salaries would be joined to Dad's, exceeding the limit. Therefore the most the family could put aside was 15 percent of $150,000, or $22,500. With the repeal of aggregation, the same family could now shelter 15 percent of each person's salary, for a total of $33,000 — a 68 percent increase.
Time to act is now
The $150,000 limit on salary applies to each family member and will be indexed annually for inflation. For the 1997 tax year, the limit will be about $160,000. There are other rules that still apply, such as how much of a qualified plan must also be offered to other employees, so owners should consult their financial planners before making changes.
Owners who want to take action would be wise to do so soon. Most qualified plans can only be altered once a year, and in many cases notification laws require that changes for 1997 be formally communicated to all employees by December 15.
There's more good news about benefit plans. Many younger workers prefer defined contribution plans (such as profit-sharing) to maximize payouts, then switch to defined benefit plans (such as pensions) in their older years to maximize funds set aside for retirement. Rules governing the switch effectively reduced the amount that could be saved over a lifetime. They have been repealed. As of January 1, 2000, there will no longer be any limits on the combined rewards of benefit plans.
Robert N. Cohen is a financial planner and principal in Cohen & Associates in Framingham, MA, who specializes in pension, profit-sharing, and estate planning issues.