HBiz Law 2010
All businesses in Hawaii, big or small, operate within a legal framework.
llen Nomura Kawashima, Partner Roger W. Fonseca, Of Counsel Jodene K. Arakaki, Associate of Cades Schutte LLP
Volume 5 Issue 2
Ignoring this body of laws—some of them unique to our Island state—can cost you an important deal or even jail time. But keeping up with changing laws and emerging legal trends can be a challenge when running a business. For this reason, Hawaii Business magazine inaugurated this special quarterly report featuring articles written in non-legalese on important issues by some of our state’s top business lawyers especially for business people. In the future, it will deal with a myriad of other legal issues that businesses continually face. Please feel free to suggest topics that you would like to see covered or how we can make this quarterly report better serve your needs.
THE MANY FLAVORS OF ERISA
Ellen Nomura Kawashima • Roger W. Fonseca • Jodene K. Arakaki
Qualified Retirement Plans • Employee Benefits • Executive Compensation • Business Law
When adopting or reviewing your retirement program, it is best to consult a pension professional about whether there are better ways to meet your tax-deferral, retirement or employee benefit needs.
Most employers are familiar with the most common – “vanilla” – types of retirement plans: profit-sharing, 401(k) and defined benefit. However, these plans offer options of which you may not be aware, and other types of plans may be a better match for your particular company and its employees. The following are some creative options to consider:
1. Cross-Testing. Many people think that employer contributions to a profit-sharing plan (or to the profit-sharing portion of a 401(k) plan) must be allocated in proportion to pay. Not so. The IRS allows such plan contributions to be allocated in any way you like, so long as you do not favor “highly-compensated employees” (owners or employees earning over $110,000 per year) and the plan document provides for such flexibility. On top of that, you are allowed to take age into account in determining if owners and high-earners are actually being “favored,” since the IRS allows larger contributions to those closer to retirement age. So, for example, if the owner is in his 50s and the average age of his staff is in the 30s, he may be able to make a contribution to his own account equal to 25% of his pay and contribute only about 5% of pay for the other employees.
2. Safe-Harbor 401(k). As a general rule, the average employee salary-deduction contribution for the company’s “highly-compensated employees” (“HCEs”) can’t exceed (a) 2 percentage points more than the average employee contribution for the non-HCEs, or (b) 125% of the average employee contribution for the non-HCEs. If your staff doesn’t contribute much to the 401(k) (or if many do not contribute anything, thereby bringing down the average), the HCEs will not be able to fully utilize the deferral potential of the plan. There is, however, a useful exception to this rule: if the company is willing to make a minimum “safe-harbor” employer contribution on behalf of all non-HCEs (either a fully-vested profit-sharing contribution of 3% of pay or a fully-vested matching contribution of up to 4% of pay), the HCEs are permitted to make any employee contributions they like, up to the legal limit of $16,500 per year ($22,000 if over age 50). In addition, the 3% safe- harbor profit-sharing contribution can be used to satisfy all/part of the minimum contribution needed to make “cross-testing” work, so a 401(k) plan can use these two techniques in tandem to produce the best results for the owners or other HCEs.
3. Owner-only Defined Benefit Plans. With good reason, employers have lately been terminating or shying away from defined-benefit pension plans because of high maintenance costs and the unpredictability of contributions, which are tied to volatile interest rates and stock market returns. But both problems are reduced or eliminated if the only plan participants are the company’s owner and his or her family. How is that possible in a world of strict discrimination laws? In at least three situations: 1) Where a company has no staff employees (e.g., many realtors, anesthesiologists, insurance agents and artists), 2) where the staff employees are so young or frequently turn over that they never meet the legal eligibility rules of 2 years of full-time service and attainment of age 21, or 3) where all staff employees are unionized and thus excludable by law. In these special circumstances, defined benefit plans still offer the only way to double or triple the maximum annual contribution limits imposed on all other types of plans. Additionally, a company can adopt both a defined benefit and a 401(k) plan, thereby further increasing the tax-deferred contributions that can be made for key employees.
4. Cash Balance Plans. What do you do if you want the large contribution of a defined benefit plan but have several staff employees or several unrelated owners who would be difficult to manage under the inflexible defined benefit rules? There is a fairly recent hybrid arrangement called a cash balance plan which provides the best of both worlds: large deductible contributions but separate participant accounts. By combining the cash balance plan with a 401(k) plan, the staff employees’ share in the large cash balance contributions can often be kept quite low.
5. Davis-Bacon Plans. The Davis-Bacon plan is available to only a limited number of employers: non-union companies that work on federal projects governed by the Davis-Bacon Act or on state or county projects governed by Hawaii’s “Little Davis-Bacon Act.” These labor laws require that every non-union company working on a government project pay its employees a minimum hourly wage which is comparable to the union wage in that area. A significant portion of this wage, however, can be paid in “fringe benefits,” including qualified retirement plans, rather than straight salary. Thus, if a non-union company is required to pay its employees $16 an hour on a particular project, and the company decides to put $7 of that amount into a profit-sharing plan, it has accomplished two extraordinary things: First, it has reduced taxes for both the employer and the employee with respect to that $7, because contributions to a qualified plan are free from employment-related taxes, and distributions from a qualified plan after retirement are exempt from Hawaii state income tax. Second, since the IRS merely requires that retirement plan contributions be “non-discriminatory,” without caring where those contributions come from, the company can make the contributions for its rank-and-file out of the Davis-Bacon minimum wage dollars (which it would otherwise have had to pay out in salary) and make equivalent contributions to the owners and management employees out of its own funds.
6. Employee Stock Ownership Plans. The ESOP is another type of retirement plan that is not for every company, but one that provides extraordinary tax benefits for the right employer. Basically, an ESOP is a type of profit-sharing plan designed to invest primarily in the capital stock of the sponsoring corporation. Contributions can be made in the form of either cash or stock, and the assets in the trust can also be used to buy stock either from the company or from its existing stockholders.
Companies can benefit from an ESOP in a variety of ways. For example, if the existing stockholders wish to sell the company but have no ready market for their stock, they can have the ESOP buy their stock (either over time based on money received in annual contributions or immediately based on a loan that the plan makes from a local bank) and the ESOP in turn will slowly distribute the stock to the employees. If it is desired that one or more key employees exert majority control, those employees can be sold or bonused additional stock on the side. As for the selling stockholders of the company, they have not only found a market for their shares but, if the company is a C corporation, they may be able to reinvest the proceeds of their stock sale into the stock of unrelated companies and defer tax until the replacement shares are sold. This effectively allows the selling stockholders to defer tax on the sale of their company indefinitely.
Although previously not permitted, ESOPs are now allowed to own stock in an S corporation. The law provides that any profits attributable to the ESOP’s ownership of stock in an S corporation are not subject to federal income tax. Thus, an S corporation that is 100% owned by an ESOP may not pay any taxes at all. However, this significant benefit comes with certain costs and complexities not otherwise applicable to corporation ESOPs.
7. 409A Deferred Compensation Plans. Certain deferred compensation plans are not “qualified” under the Internal Revenue Code. On the one hand, this means that the company will not get a deduction for plan contributions until benefits are paid out taxably to the employees, plan investment gains are taxed currently to the company, and plan benefits do not receive creditor protection. On the other hand, a nonqualified deferred compensation plan is generally not subject to the Code’s discrimination, funding, vesting and distribution rules. It is also exempt from most government reporting rules. A company willing to forego the tax benefits and creditor protection of a qualified plan may therefore design a deferred compensation plan to reward precisely those employees on precisely those terms that will best serve its goals. Recent legislation has placed some broad restrictions on the way benefits may be provided under nonqualified plans; however, companies still retain considerable discretion in the design and operation of these arrangements.
Some popular types of deferred compensation plans are the Incentive Bonus Plan (which defers bonuses for a number of years, or until attainment of a certain age, or until termination of employment), the Salary Reduction Plan (which allows employees to defer a portion of their regular wages to termination), the Supplemental Employee Retirement Plan (which uses a nonqualified plan to replace qualified plan benefits which highly–compensated employees lose because of the legal limits on those plans), and the Phantom Stock Plan (which provide deferred compensation equal to the amount by which the company’s stock has increased over the course of the employee’s employment, even though the employee is never actually a stockholder).
There are a host of options available to a company wanting to provide greater retirement benefits to its owners and/or its key employees. For those interested in the more exotic flavors of ERISA, your pension professional can assist you in developing the best retirement recipe for your company.
This article is intended to address issues of general interest and is not intended to constitute legal advice or to substitute for the advice of legal counsel.
Do you like what you read? Subscribe to Hawaii Business Magazine »