In the “old days” business owners and employees were able to have good pension plans that did not depend upon the fate of the stock market, i.e. defined benefit plans. We have all heard the stories of New York City fireman or policemen who retire at age 45 after twenty years of service at 75-100 percent of their final pay. Those types of pension plans are long gone. Well, maybe not!
The predicted storm with respect to tax reform did not turn out to be the perfect storm. The top marginal bracket for taxpayers with more than $400,000 (single and $450,000 married) increased to 39.6 percent. Taxpayers with adjusted gross income in excess of $250,000 will pick up an additional 3.8 percent on unearned income raising the top marginal bracket to 43.4 percent. These same taxpayers will also be exposed to the phase out of personal exemptions and miscellaneous deductions. These phase outs effectively raise the marginal bracket by 1-2 percent. Taxpayers in the top marginal bracket will end up with a top federal bracket of 45.4 percent. High income states such as New York and California add an additional 8-10 percent bringing taxpayers to a combined marginal tax bracket of 53-56 percent.
The benefits of qualified retirement plans often lose a lot their luster due to the requirements to provide non-discriminatory participation and benefits for employees. It suddenly makes the plan expensive when the business owner has to contribute for someone else other than himself.
This executive summary will discuss how a business owner or owner of a professional practice can elect to cover his employees under a collectively bargained agreement with a union for retirement and benefits purposes. As a consequence, the business owners will be able to establish the type of benefit plan that optimizes benefits for the business’ principals – a defined benefit plan as well as other benefit plans that are subject to ERISA.
IRC Sec 410(b)(3)(A) provides an important exception to the minimum participation rules of qualified retirement plans. This Code section exempts employees that are covered for retirement as well as health benefits under a collectively bargained agreement.
What Are the Requirements of Qualified Plans?
The ability of a business to make a tax deductible contribution to a retirement plan comes with all sorts of requirements – (1) Minimum Participation (2) Top heavy rules (3) Non-discrimination (4) Minimum coverage (5) Minimum vesting requirements and (6) Minimum funding requirements. At the same time, the business owner is handcuffed with respect to the maximum contribution under the defined contribution rules - $50,000 in 2012 and the maximum annual compensation that can be considered - $250,000.
Compliance with these rules inevitably limits plan considerations and contribution levels for the business owner due to the cost constraints of employee benefit contributions. The best option in most cases is a defined benefit plan – traditional or fully insured. Other ERISA benefit plans have similar minimum participation and coverage rules. The exemption for collectively bargained agreements eliminates these tax and regulatory obstacles.
Collectively Bargained Arrangements under IRC Sec 410(b)(3)(A)
What is a collectively bargained agreement? IRC Sec 410(b)(3)(A) states the following in its exemption:
“employees who are included in a unit of employees covered by an agreement which the Secretary of Labor finds to be a collective bargaining agreement between employee representatives and one or more employers, if there is evidence that retirement benefits were the subject of good faith bargaining between such employee representatives and such employer or employers,”
As a result, company employees pursuant to a collective bargaining agreement become union members and the business makes contributions to the union retirement and health plans instead of the company plans. These contributions to the union plan are tax deductible. As a result, these employees are no longer part of the company pension plan or benefits program. The business owner is free to establish a define benefit plan as well as a medical reimbursement plan. The only remaining employees eligible for participation in the business owner’s plan are the business owner and family members. Benefit plan contributions can be optimized for the business owner.
Union Friendly – Telling the Emperor that He Has No Clothes
Inevitably, the biggest worry of every business owner or professionals when it comes to unionized employees is the fear of the union itself. Public sentiment towards unions is politically charged and divisive. Most people either love unions or hate them.
The ‘haters’ attribute politically the economic demise of the manufacturing sector to union greed over the last several decades. On the other hand most union members that are covered by collectively bargained agreements are participants in multi-employer defined benefit plans and will have post-retiree health insurance coverage. In the meantime, the rest of us are lucky to have a company match on our 401(k) plans, or participation in a company profit sharing plan funded with company stock that has gone down by forty percent. For the latter group, the target retirement age is age 95.
In regard to this implement this strategy you need to see the union exemption as a means to an end – a comfortable retirement and lower taxation. You need to take off your “political hat” to evaluate this potential economics of this strategy. Most business owners assume the worst believing that long term employees who join the Union on Friday will be outside of the business picketing the following Monday for higher pay and paid vacations as well as becoming members of the communist party. The reality is that the unions need the business owner as much as the business owner needs the business.
The key to this strategy is working with “friendly” unions and maintaining an ongoing stable relationship. Most “friendly” unions need members and have no interest tampering with the small business.
The strategy below illustrates the possible benefits of the strategy.
Dr. Ben Casey, age 67, is a dermatologist with his own medical practice. His wife, age 65, works as his office manager. Ben takes an annual salary of $900,000 and his wife takes a salary of $250,000 on revenues of $3 million. The practice has two employees - two nurse practioners as well as a bookkeeper and a receptionist. The senior nurse is 55 years old and has a salary of $65,000 per year. The junior nurse is 50 years old with an annual salary of $40,000. The bookkeeper, age 60, has an annual salary of $30,000. The receptionist, age 50, has an annual salary of $25,000.
The Casey Medical Group enters in to a collective bargaining agreement with the Medical Worker Union. Each employee will pay union dues of $35 per month which will be reimbursed by the practice. The employees will be covered for retirement and health insurance purposes under the union plan. The employee’s previous plan in the medical practice was a 401(k) plan with no employer matching. Pension contributions to the union plan are approximately $9,600 dollars per year. The health insurance contributions are $4,000 per year.
The medical group establishes a new defined benefit plan covering Dr. Casey and his wife. A fully insured defined benefit plan option funded with annuities only provides for a combined tax deductible contribution of $1.24 million. The plan targets the maximum retirement benefit beginning in five years. A different funding version of this plan using life insurance and annuities as funding vehicles, increases the annual contribution to $1.5 million per year.
A traditional defined benefit plan would allow a combined tax deductible contribution of $642,000 per year. Additionally, the Caseys are able fund their 401(k) with contributions of $22,000 each ($17,000 max contribution in 2013 plus a $5,500 catch up for participants that are older than age 50). They are also contributing to a profit sharing plan in an amount equal the maximum annual compensation limit, $250,000. Their profit sharing contribution is $15,000 per plan. The Caseys combined qualified pension contributions are approximately $1.6 million per year.
The ability to maximize the ERISA exemption for collectively bargained agreements provides the opportunity to streamline benefit costs for employees while maximizing contributions for the business owner. In all likelihood, the employees may end up with a better benefit plan at a lower cost while providing the business owner to pursue the type of benefit programs that he might have pursued but for all of the tax and labor regulatory restrictions. In the current environment the solution also provides excellent tax benefits – income tax reduction and deferral. The business owner’s preconceived notions and anxiety about unions are unjustified and overshadowed by the personal.