If you are a small business owner who recently established a retirement plan for your business, you may be eligible to receive a nonrefundable tax credit for expenses you incurred to implement the plan. This is in addition to any tax deduction you may receive for plan contributions. The tax credit may be claimed for a maximum period of three years. Here is an overview of the rules that apply to claiming the tax credit.
The tax credit is available to employers with no more than 100 employees who earned at least $5,000 in the previous year. For instance, assume an employer established a retirement plan for year 2013. The employer is eligible for the credit if, in 2012, the business had no more than 100 employees who received at least $5,000 in compensation. (An employer with more than 100 employees may still be eligible if no more than 100 of the employees earned at least $5,000.)
Should an employer meet this requirement one year but fail to do so in a subsequent year, the employer is allowed a two-year grace period to claim the credit. For example, assume ABC Inc. met the requirements in 2011, but exceeded the 100-employee limitation in 2012 and 2013. ABC Inc. is still eligible to claim the credit for year 2012 and 2013 because of the two-year grace period.
Eligible plans include SEP IRAs, SIMPLE IRAs and qualified plans, such as 401(k) plans, profit-sharing plans, money-purchase pension plans and defined-benefit plans. The plan must cover at least one employee who is not classified as a highly compensated employee (HCE). An employer may elect to choose an alternate definition of HCE as allowed by the plan. Also, there may be circumstances that affect whether an employee who meets either of the above requirements is classified as an HCE for the applicable year. For instance, an individual who owns at least 5% of the business may not be counted if he or she did not perform service for the employer during the applicable year. To be sure, employers should check their plan documents to determine the applicable definition of HCE.
Employer Aggregation Rules Apply
The employer aggregation rules apply to the tax credit. This means that if more than one business is under common control, they may be treated as one for plan purposes. An employer who owns more than one business should consult with a tax attorney to determine whether he or she is subject to the employer aggregation rules.
Eligible Expenses and Applicability
Expenses eligible for the tax credit include those defined as the plan's start-up costs, which are ordinary or necessary for the establishment of the plan. These include expenses incurred to establish the plan, administrative fees and costs incurred to educate employees about the plan.
The credit is limited to 50% of the first $1,000 in expenses; therefore, the credit cannot exceed $500. The credit is nonrefundable; therefore, the employer may not generate an income tax refund for the credit.
Unable to Claim the Credit This Year?
Claiming the credit is optional. An employer may instead choose to treat the amount as regular deductible business expenses. Employers who owe no tax may prefer this option, as the tax credit for plan expenses is a reduction in tax liability. This means that if the employer owes no tax, he or she will not benefit from the tax credit. However, it is very important to note that if an employer is unable to claim the credit in one year, he or she may choose to claim it for a previous or subsequent tax year. For instance, if the credit applies to tax year 2012, the employer may choose to claim it for 2011 or 2013.
Tax Filing Requirement
To claim the credit, the employer must file IRS Form 8881 - Credit for Small Employer Pension Plan Startup Costs.
Be sure to consult your tax professional about this and other plan benefits, such as the increased contribution and deduction limits and exceptions that apply to small business owners. These benefits can be added incentives for establishing a plan for your business, which, in turn, will help to attract high-quality employees and boost employee morale.
The Bottom Line
As with any other matter relating to retirement plans, employers are urged to seek competent tax advice to ensure that their elections are within the parameters of the law and in their best interest and that of the plan.