By Robert Mand, Esq. & Kenneth Marblestone, Esq.
Despite recent changes in the tax laws reducing the maximum tax rate to 35 percent, a qualified retirement plan remains one of the most valuable opportunities for physicians to defer current taxation on their income. Because plan contributions are currently deductible, and the growth on the plan assets is not subject to tax while in the plan, there is an extremely powerful financial incentive to establish and maintain such a plan.
The challenge that physicians face is how to ensure that the plan operates for their benefit. If the physician is giving away 50 cents of every dollar he or she contributes for the benefit of the office staff, one may well conclude that the economic value of the plan to the physician is less than ideal. Without a plan, the physician typically would be able to retain between 60 and 70 cents of that dollar after taxes. Therefore, the objective for an “owner-centric” retirement plan is to produce a result that makes the plan economically viable for its sponsor: maximizing plan contributions for owners (and perhaps some other favored employees) while keeping staff contribution costs at the lowest possible level, so that the physicians retain more of the aggregate plan contributions than they would keep after taxes in the absence of the plan.
To be responsive to the concerns of today’s medical practices, an owner-centric plan should be adaptable to accommodate changes to employee demographics, normal (and unusual) business cycles and changing tax laws. The ideal owner-centric retirement plan also should be able to deal with such practical issues as satisfying physician-owners who have different contribution objectives, dealing appropriately with the expenses of covering non-owner physicians, and being able to maximize contributions for physicians’ family members who work in the practice.
The difficulty in developing the ideal plan is that, in order for a physician-owner plan sponsor to obtain the tax and financial benefits of a tax qualified retirement plan, the plan may not discriminate in favor of highly compensated employees. The definition of a highly compensated employee for plan purposes includes a physician owning more than five percent of the practice, his or her family members, and any non-owner employees who had compensation in excess of $90,000 in the prior year. A plan which fails to provide the appropriate level of benefits for non-highly compensated employees will violate the non-discrimination rules set forth in the law and Treasury regulations, and will lose its tax qualification.
Because the allocation of retirement plan contributions is governed by the plan document, most plans are inadequate to deal with these changing circumstances. Typically, plan provisions describing a participant’s entitlement to an allocation, including the rate at which such allocation must be made (either as a fixed percentage of compensation or as a rate related to the rates contributed for other participants), and the discrimination testing methodology used to determine such allocation, are “hard-wired” in the document, i.e., the plan language requires specific and fixed protocols to be followed.
These mandated plan document rules often present insurmountable challenges to the legal, tax, actuarial and consulting professionals who advise physician-owners in the structure and operation of their retirement plans. Because the annual benefit under a plan typically is accrued no later than the last day of a plan year, a plan may not be amended after the end of the plan year to apply retroactively in a manner that adversely affects the contributions of non-highly compensated employees. Nevertheless, it is most frequently after the end of the year that changes are communicated to the retirement plan servicing professional, at which time it is too late to react for the year in question. As a result, the plan contribution may have extremely negative financial consequences for the practice.
As will be discussed below, the solution to the difficulties facing the physician’s qualified plan is the OCPP SM (“one category per participant”) plan design, which has received IRS approval and is directly responsive to the needs of an owner-centric plan, including adaptability to employee demographic changes, as well as other numerous changes that regularly occur in a medical practice.
An OCPP SM 401(k) profit sharing plan design permits different profit sharing contribution rates for every plan participant (to the extent needed to meet the physician owner’s objectives and to pass discrimination testing). The contribution rates are not defined in the plan document; rather, the contribution is declared each year by the plan sponsor, and such declaration does not need to be made until the extended due date for filing the plan sponsor’s income tax return for the prior year. For example, a professional corporation operating on a calendar year basis does not need to declare or make its 2004 contribution until March 15, 2005, which date may be automatically extended to September 15, 2005. The due dates for a sole proprietor, calendar year-based partnership or LLC is April 15th of the following year, which may be automatically extended to August 15th, with a further extension to October 15th, if approved by the IRS.
Although the contribution made on behalf of each participant is subject to discrimination testing, the OCPP SM plan design document does not specify the discrimination testing methodology that must be used to satisfy statutory and regulatory requirements. As a result, based upon the particular set of circumstances in a given year (e.g., employee demographics, compensation level of physicians, cash flow, etc.), a discrimination testing methodology is selected that will best meet the plan sponsor’s objectives in that year. Because the testing methodology is not “hard-wired” into the plan document, the plan sponsor has complete flexibility in determining the amounts to be contributed on behalf of each participant, subject only to satisfaction of the legal requirements for the specific testing methodology being used. The contribution pattern in any year does not have to be repeated in a subsequent year.
While a detailed discussion of these discrimination testing methodologies is beyond the scope of this article, the optimum result always may be obtained using the OCPP SM plan design. By considering each employee as an individual category for which a contribution is to be made, the plan document ceases to be a limitation as to the manner in which contributions are determined and discrimination is tested.
The following examples are situations that frequently occur in a medical practice to which the OCPP SM plan design may be responsive without the need for a plan amendment.
Employee demographic change. Assume that as a result of age disparity, a cross-tested, new comparability plan has allowed maximum physician contributions at an acceptable employee contribution cost. If younger employees terminate employment and are not replaced in the plan by similarly-aged employees, the “hard-wired” job categories and discrimination testing requirement in the plan document will result in a substantially increased employee contribution expense, which may be so large that the employer’s only viable option is to eliminate the entire profit sharing contribution for the year in question. The OCPP SM plan design document solves that problem by allowing contributions to be declared at different rates for select, favored employees, and also by permitting any discrimination testing methodology to be used that will satisfy IRS regulations.
Younger partner enters practice. In a cross-tested, new comparability profit sharing plan design, the most favorable results occur when all owners are older than most of their employees. When a younger, highly compensated employee is part of the cross-testing discrimination test, the contribution objectives may not be satisfied in the most favorable manner. An OCPP SM plan design allows an array of discrimination testing methodologies to be used to meet the contribution objectives. This frequently involves an enhanced contribution to select, favored non-highly compensated employees, thereby allowing all physicians (including the youngest) to achieve maximum contribution levels, while maintaining the aggregate employee contribution cost at an acceptable level.
Family members in practice. A physician’s spouse and/or children may often be employees of the practice. Because the family attribution rules treat the spouse and children as highly compensated employees, regardless of compensation level or lack of ownership, family members’ ages and compensation levels create challenges to overcome in order to achieve physicians’ contribution objectives. An OCPP SM plan design document allows family members to be integrated into the plan design in the most favorable manner, allowing different contribution rates and alternative discrimination testing methodologies.
Annual changes. Any of the above examples, as well as others, often change on a regular basis. For example, a favored employee (receiving an enhanced contribution to satisfy discrimination testing and achieve desired results) may terminate employment, thereby necessitating a different approach. The OCPP SM plan document meets this challenge because it does not require contribution patterns or discrimination testing methodologies to be consistent on a year-to-year basis. Different employees may be favored and different testing methodologies may be used each year to deal with changed circumstances.
Because the OCPP SM plan document allows the maximum flexibility permitted by law, the annual contribution analysis must be at the highest level to ensure that the plan remains compliant with all applicable legal requirements. For example, the legal/actuarial consultant to the plan must have an understanding and appreciation of the prohibitions against age discrimination. Age discrimination is prohibited under several federal statutes, including the Age Discrimination in Employment Act (ADEA) as well as under ERISA and the Internal Revenue Code. Because age is a factor in calculating contributions in cross-tested defined contribution plans, any contribution weighted in favor of younger employees on the basis of their age would be the basis for an age discrimination claim. This may put the plan administrator at risk for personal liability exposure, and also may jeopardize the tax-qualified status of the plan.
The retirement plan is not “the tail that wags the dog.” Rather, a physician’s business objectives must be defined and the tax qualified retirement plan should be a critical part of achieving those objectives. Tax qualified retirement plans remain among the most powerful financial and tax planning techniques available to physicians. A well-designed plan will meet the medical practice’s objectives in several respects: flexibility in the amount of the contribution, its ability to provide larger benefits for favored employees, and its responsiveness to changing circumstances. The OCPP SM plan design is the most sophisticated approach currently available to satisfy these objectives.
Robert Mand, Esq., and Kenneth Marblestone, Esq., are principals in the Bala Cynwyd law firm Mand Marblestone & Danziger, P.C., which obtained IRS approval of the OCPPSM plan design for its retirement plan clients.