Retirement Plans for Small Businesses – Penalty Assessments Causing Unintended Fear

Bill Norwalk
October 8, 2009 — 1,387 views  
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In light of recent penalties imposed relating to retirement plan deductions, is it prudent for a business to adopt a retirement plan?

To an experienced tax practitioner, this may seem like a ridiculous question.  We recognize the benefit of getting current tax deductions combined with tax deferred growth in the funds (assuming positive investment returns).  Additionally, we realize that a deferred benefit plan for an older employee-owner can legally defer almost $200,000 of income for that individual. So why did one of my clients recently come to me, expressing discomfort with even considering this strategy?

This S Corporation is on the verge of earning significant profits for the first time in several years.   The company does not have a retirement plan in place, so we had been discussing the possibility of implementing a retirement plan that was heavily weighted to benefit older, more highly compensated employees (such as my 64-year-old client).  Over the years, our firm has often recommended that our clients have a pension administrator calculate the benefits of various retirement plans and present the advantages and disadvantages of each alternative.  For this specific client, I had discussed a similar plan of action, reviewed the strategy and the pros and cons, and, quite frankly, was expecting my client to enthusiastically embrace the concept.

Less than 2 days after our meeting, my client sent over an article from The Wall Street Journal that described what can only be called a horror story of how certain small businesses were facing  bankruptcy due to IRS enforcement actions relating to participation in a retirement plan.  The September 19, 2009 article, “Small-Business Owners Fret Over Large IRS Fines” states that the “victims” relied on advisors including CPAs, and yet were still penalized for amounts far in excess of the benefits derived.  My client noted the ironic timing of the article – it almost seemed that the IRS was listening in on our meeting. 

The Wall Street Journal article explained that the penalties stem from tax-law changes made by Congress in 2004.  Lawmakers were concerned that tax shelters, especially from large corporations, were costing the Treasury billions of dollars in revenue.  To combat this, Congress imposed Code Sec. 6707A, which established enormous fines on taxpayers who fail to disclose to the IRS their participation in any transaction that might be considered a tax shelter.  Included in this definition of a tax shelter are over-funded benefit plans funded with cash-value life insurance policies, similar to the plan adopted by the business owners featured in the Wall Street Journal article.  The subsequent IRS determination that these plans were over-funded triggered the life-changing penalties.  The taxpayers profiled had no idea that their plans fell in to the definition of a tax shelter, and therefore, were not properly reported and fell subject to the penalties.

It is clear to me that funding a retirement plan that makes qualified investments and that follows reporting requirements remains a sound strategy.  It’s unfortunate that a certain segment of taxpayers were inadvertently caught up in the reporting rules – the angst and anxiety this must have caused was clearly quite real and likely cost these taxpayers dearly.  The ensuing wholesale fear in the small business community over the core strategy, however, is unfounded. 

Small business owners should be aware that the IRS is actively working to mitigate the effects of Sec 6707A’s penalties on small businesses.  Earlier this summer, the IRS announced that it would suspend efforts to collect penalties where the annual tax benefit from the transaction is less than $100,000 for individuals or $200,000 for other taxpayers.  This suspension is currently in place until December 31, 2009.

As practitioners and trusted advisors, our role is to ensure that our clients understand both the risks and rewards of each strategy, and in this instance, to specifically understand the serious nature of the penalties that can be imposed.  Should any doubt exist as to whether a transaction might qualify as a listed transaction and be disclosed, we should certainly err on the side of caution and propose disclosure, rather than toss a time-tested beneficial tax and business strategy out the window.

Ireland San Filippo ( is an integrated service public accounting and consulting firm that brings actionable business solutions to its clients through its unique brand of service, industry-specific knowledge, technical expertise and its ISF Knowledge Series publications and classes.  Key industries of specialization include construction and real estate development, venture-backed technology, charitable organizations and private foundations, agribusiness, manufacturing and venture capital.  15 partners and over 90 employees deliver ISF’s knowledge-based services to clients throughout the greater San Francisco Bay Area.  Further questions can be addressed to:  [email protected]

Bill Norwalk

Ireland San Filippo, LLP