Small business tax solutions.

This is the first in a regular series covering taxation issues of special interest to small businesses based on questions from the American Institute of CPAs tax certificate of educational achievement courses on tax planning and advising for closely held businesses. This month, Deborah Walker, CPA, chairperson of the American Institute of CPAs tax executive committee and partner in charge of KPMG Peat Marwick's Mid-Atlandtic compensation and benefits division, and Greg Matthews, CPA, partner of G. E. Matthews & Associates, St. Petersburgh, Florida, cover employee benefits and compensation.

Q What are the remaining deadlines for businesses to amend qualified plans to comply with the Tax Reform Act (TRA) of 1986?

A In general, plan documents for pension, profit-sharing and stock bonus do not have to be amended to reflect legislative changes in the 1986 TRA or in the Omnibus Budget Reconciliation Act of 1993 until the last day of the first plan year beginning in 1994; calendar year-end plans generally had to be amended by December 31, 1994. (A unique delay in the deadline to formally amend the plan was available for certain standardized plans but required that the employer complete a certification to adopt the standardized plan by December 31, 1994.)

Qualified pension and profit-sharing plans with calendar year ends that will be submitted to the Internal Revenue Service for a plan qualification letter--and plans with January, February and March year ends--have until March 31, 1995, to complete their fillings. (The IRS filing requires that participants receive a preliminary notice 14 days before the determination filing. Thus, the required date to commence the determination letter process would fall even earlier in March.) Other fiscal year plans have until the end of the fiscal year that began in 1994 to comply with the TRA provisions, the $150,000 limitation and the new rollover rules. The IRS has not given an extension to individually drafted plans with December 31 year ends beyond the original December 31, 1994, deadline but the service did delay the time period for seeking a determination letter for certain nonstandardized prototype plans in revenue procedure 95-12. Missing the deadline violates the tax code and could lead to plan disqualification.

Q How are the family aggregation rules applied to qualified retirement plans?

A There are two separate and distinct limits under the family aggregation requirements:

1. Compensation for certain participating family members is capped; their total compensation for plan benefit or allocation purposes is limited to $150,000.

2. Compensation and deferrals for a family group are aggregated into a single percentage for the 401(k) actual deferral percentage (ADP) test. Compensation and matching contributions also are grouped for the 401(m) actual compensation percentage (ACP) tests.

Family aggregation applies only to highly compensated employees who are either 5%-or-more owners or are among the 10 highest paid employees. Internal Revenue Code section 414(q)(6) requires a reduction in the compensation used to calculate benefits for these individuals, their spouse and children under 19 if the total compensation exceeds $150,000. Thus, if a participant, spouse and child earn $200,000, $100,000 and $50,000, respectively, their total pay would be capped at $150,000. If the plan covering the group provided a 10%-of-pay contribution, the total contribution for all three would be $15,000, not $35,000.

Pay can be reduced in one of several ways, depending on how the plan is drafted. Probably the most common is an across-the-board pro rata reduction, giving this participant $75,000, the spouse $50,000 and the child under nineteen $25,000. Another method is to limit the participant with the highest paid to $150,000 and then allocate the remainder to the next highest paid until exhausted. Incidentally, this reduction in compensation does not apply to IRC section 415--perhaps an oversight by Congress--unless the plan document says otherwise.

Another aggregation applies to 401(k) plans, and it's applied after the reduction in compensation. For this limitation, the family group expands to include the spouse and all lineal ascendants and descendants and their spouses. For this group, the rules combine all compensation, deferrals and matches to produce one percentage for the ADP test and another for the ACP test. All children--not just those under 19--are included in the 401(k) aggregation, but their individual compensation is limited to a separate $150,000.

An example of the family aggregation reduction applied to a family of four participants is shown in the exhibit below. Note that the first step is to aggregate the compensation of husband, wife and child under 19.

The deferral percentage for the aggregated family group would be 9.90% (that is, $29,720 in total deferrals divided by $300,000 in total compensation).