Pension changes in new tax law

By Jeffrey B. Sansweet, Esq.

Several beneficial changes for employers

The Small Business Job Protection Act of 1996 contains numerous provisions relating to qualified retirement plans. This article will summarize those pension changes which are most likely to affect physicians and their practices.

In an effort to provide small employers with a simplified form of retirement plan, a new type of plan has been created called the SIMPLE Plan, which stands for Savings Incentive Match Plans for Employees. Although I believe SIMPLE goes a bit too far as an acronym, it is another viable alternative to consider, especially for a start-up practice.

A SIMPLE Plan may be adopted starting in 1997 by employers with no more than 100 employees who earned at least $5000 in the previous year. The employer cannot maintain another qualified plan if it adopts a SIMPLE Plan. The Plan allows employees to make elective contributions up to $6000 per year (as compared to up to $9500 for 401(k) plans). The Plan must be open to every employee who received at least $5000 in compensation from the employer during any two preceding years and is reasonably expected to receive at least $5000 in compensation during the year.

Employers must satisfy one of two contribution formulas. Under the matching contribution formula, employers are generally required to match employee contributions on a dollar-for-dollar basis, up to 3 percent of an employee’s compensation for the year. Under an alternative formula, an employer may choose to make a non-elective contribution of 2 percent of compensation for each eligible employee irrespective of whether the employee has made any elective contribution. All contributions must be 100 percent vested. The complicated non-discrimination rules of Section 401(k) do not apply to SIMPLE Plans. Also, the annual reporting requirements are much less than for other qualified plans.

For those practices which do not maintain a qualified plan or which have a 401(k) plan, a SIMPLE Plan will be worth consideration. However, for practices which maintain a typical Money Purchase Pension Plan and/or Profit Sharing Plan and wish to continue contributing in the range of $20,000 to $30,000 per year per physician, a SIMPLE Plan will not work due to the $6000 elective contribution limit, even with a 100 percent match.

401(k) plans are becoming increasingly popular among small employers in general, including physician practices. The Tax Act has made some changes in this area to simplify certain calculations. As mentioned above, 401(k) plans are subject to certain non-discrimination tests to ensure that highly compensated employees are not benefiting under the plan in an excessive manner as compared to non-highly compensated employees. For plan years beginning after December 31, 1998, the Tax Act creates a safe harbor from those non-discrimination tests if the employer makes a non-elective contribution of at least 3 percent of each eligible non-highly compensated employee’s compensation, regardless of whether the employee makes any elective contributions under the plan. Another way to meet one of the new design-based safe harbors is by the employer making a matching contribution on behalf of each non-highly compensated employee of 100 percent of the employee’s elective contributions up to 3 percent of compensation and 50 percent of the employee’s elective contributions to the extent that they exceed 3 percent, but not 5 percent, of the employee’s compensation. Under this matching contribution rule, the match rate for highly compensated employees cannot be greater than the match rate for non-highly compensated employees at any level of compensation.

Other 401(k) changes are effective in 1997. Tax-exempt organizations shall be permitted to establish 401(k) plans. In addition, in order to allow employers to have a greater degree of certainty with the actual deferral percentage and actual contribution percentage tests (what I previously referred to as the non-discrimination tests), those percentages for the non-highly compensated employees in the prior year may be compared to the percentages of the highly compensated employees of the current year. This should almost completely eliminate adjustments during and after the year based upon changes in elections and employee terminations, as the employer will know exactly how much the highly compensated employees may defer since that is based upon actual data from the prior year. Also, if any distributions of excess contributions are necessary, they will now be made first to those highly compensated employees who have the greatest deferral amounts, rather than those who have the highest actual deferral percentage.

Although not part of the Tax Act, the Department of Labor has recently issued regulations that are effective on February 3, 1997 which mandate that employee 401(k) elective deferrals be contributed to the plan by no later than the 15th business day of the month following the month in which the participant contributions are withheld from the participant’s paycheck.

Another change that is not specific to 401(k) plans, but its greatest impact will be on the non-discrimination testing under such plans, is the new definition of highly compensated employees (HCEs) effective in 1997. The new definition, which is much simpler than the previous definition, includes as HCEs any 5 percent owners, and employees who had compensation from the employer in excess of $80,000 during the preceding year and, if the employer so elects, was in the top-paid group (i.e., top 20 percent of employees by compensation) of the employer.

Another important provision in the Tax Act is the repeal of the family aggregation rules effective for plan years beginning after December 31, 1996. These rules had required that compensation paid to (or plan contributions made on behalf of) family members of certain highly compensated employees was treated as paid to or on behalf of the highly compensated employee. This had the onerous effect of limiting, for example, two married physicians in practice together to a total contribution of $30,000 even if they each received compensation in excess of $150,000.

Two changes in the distribution rules have created opportunities for certain individuals. For plan years beginning after December 31, 1999, five-year forward averaging for lump sum distributions is repealed. However, prior law rules that applied to individuals born before 1936 remain in effect. Those rules allow an individual to elect ten-year forward averaging using 1986 tax rates for a lump sum distribution and capital gains treatment for the pre-1974 portion of said distribution. In addition, the Tax Act suspends the 15 percent excise tax on excess distributions (i.e., those that exceed $155,000 per year or a lump sum of $775,000) for distributions made in 1997, 1998 and 1999. Distributions made during those years are treated as made first from amounts not “grandfathered” within the Code Section 4980A(f) election. Howeve

r, the 15 percent estate tax on excess accumulations continues to apply. Also, the 10 percent tax on withdrawals prior to age 59 1/2 still applies.

Defined benefit plans have practically become dinosaurs with physician practices. They may return in the year 2000. At that time, the overall limit on annual contributions made on behalf of an employee who participates in both a defined contribution plan and a defined benefit plan maintained by the same employer will no longer apply. That may enable physicians to participate in a defined contribution plan who have been previously unable to participate because they were “maxed out” under a terminated defined benefit plan.

A final change that may affect physician practices is clarification of a portion of the test to determine whether an employer has leased employees subject to coverage under their Plan. The prior test, under which individuals could be considered leased employees of the recipient and thus entitled to participate in the retirement plan if the services were of a type historically performed by employees of the recipient, has been repealed. The new rule will not require leased employee status unless the individual’s services are performed under the primary direction or control of the recipient employer.

In summary, there are several pension law changes in the Tax Act that have possible implications to physicians and their practices. For a change, most of the changes may be beneficial, as opposed to costly as most changes in the past have been.

Jeffrey B. Sansweet, Esq. is a principal of the Wayne health care law firm of Kalogredis, Tsoules and Sweeney, Ltd.