A 412(e)3 plan, also commonly referred to as a Fully Insured Defined Benefit Plan, or sometimes a Pension Plan, is one commonly overlooked tax benefit for businesses and business owners. Eligible businesses for this plan are; Sole proprietors, C Corporations, S Corporations, Partnerships, Limited Liability Companies, and Family Limited Partnerships. This plan is primarily used for pass through entities, so we rarely see them for C Corps.
Section 412(e)3 or the IRS code allows the largest tax-deductible contribution to a qualified retirement plan. In many cases this gives a business and/or individual a 6-figure tax deduction. We have even seen cases in which it offers 7 figures in deductions, the largest we've seen being a $2.2 million deduction. The great news is, if we act fast, there is still time to get this in place for a 2019 deduction.
A thought to keep in mind; generally, the older the individual, the larger the contribution they can make. Remember, the benefit is defined, not the contribution. This means that when an individual is older, they can “catch up” to the maximum defined benefit through larger contributions.
A common use we’ve seen for this plan is incorporating IRC section 199A. This section was created by the Tax Cuts and Jobs Act. This allows eligible taxpayers a deduction of up to 20 percent of qualified business income (QBI) from a domestic business operated as a sole proprietorship or through a partnership, LLC, S corporation, trust or estate. You get the full 20% deduction up to $315,000 filing jointly, $157,000 for all other tax payers, which can apply to; Individuals, trusts and estates with qualified business income, qualified REIT dividends or qualified PTP income. In some cases, patrons of horticultural or agricultural cooperatives may be required to reduce their deduction. The IRS will be issuing separate guidance for co-ops.
What does this mean? It means that if your QBI is $300,000 for the year (married filing jointly) you get a 20% deduction and are only taxed on $240,000 of that income. This benefit can be substantial, especially considering that individuals in this realm tend to be in the higher income tax brackets.
To give you a real-world example; we recently had a client come to us that operates as a sole proprietorship. After this individual worked with their CPA and deducted all their qualified business expenses (QBE), their QBI was still $425,000 for the calendar year 2018. We then worked with our client and their CPA to put in place a 412(e)(3) plan by making an annual contribution of $115,000 a year. This reduced their QBI to $310,000 and made them eligible to take full advantage of section 199A, giving them an additional 20% deduction on the $310,000.
To summarize some of the key advantages:
- A fully insured 412(e)(3) DB plan can provide substantial retirement benefits without market risk;
- From a retirement standpoint, it gives the largest tax deduction under the law.
- Can provide guaranteed income you cannot outlive, a maximum annual benefit of about $220,000 a year.
- Reduces, diversifies or potentially eliminate market risk.
- Allows you to buy estate planning tools on a pre-tax basis.
- Because benefits are funded based on the contract guarantees, the 412(e)(3) fully insured DB plan can provide a maximum current tax-deductible contribution for the business;
- There is no full-funding limitation under IRC Section 404(a)(1)(A);
- No quarterly contributions are required; and
- There can be no under-funding because contributions are based on the guaranteed provisions of the level premium contracts.
While all the above sounds great, there are some disadvantages to this plan:
- It requires large contributions that must be made each year;
- No policy loans are available;
- There is no flexibility in contribution allocations; and
- It must be funded exclusively through annuity and life insurance contracts (in order to remove all market risk).
If you’ve made it this far in the article/newsletter I’d first like to applaud you for having a greater attention span than most. I’d also like to thank you for tolerating my dull writing on this particular subject. If we have raised any questions, or if you’d like to see if you’re eligible for this strategy, please feel free to reach out to our office or contact me directly. We are happy to provide our subscribers a free cost savings analysis for this strategy.
Founder, Managing Partner
Finance For Thought
O: (212) 534-1200