Credit for Small Employer Pension Plan Startup Costs

An employer may deduct the costs associated with establishing and maintaining a qualified retirement plan. These costs include, but are not necessarily limited to the cost to design, set-up, modify payroll systems (e.g., to accommodate 401(k) plan participant elective deferrals), educate participants and administer the plan. These expenses are generally deductible as ordinary and necessary business expenses.

The Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") added Section 45E to the Internal Revenue Code. This section provides a tax credit up to $500 as an incentive to certain employers to establish new plans. The amount of the credit is 50% of the first $1,000 of the administrative and employee education expenses with respect to plans established after 2001. The credit is available for the first year in which the plan is effective and the next two-(2) taxable years. (An employer may elect to apply the first year credit to the taxable prior to the year the plan is effective. For example, if an employer designs and adopts a plan in 2002 to be effective January 1, 2003, the employer may elect 2002 as the first credit year to alleviate plan startup costs.) Whereas the ordinary and necessary business expense deduction reduces tax at the employer's marginal rate, the credit is a dollar-for-dollar reduction of tax liability. In addition, plan expenses in excess of the credit are deductible under the pre-EGTRRA rule as ordinary and necessary business expenses.

Who is eligible for the credit? Small employers are eligible for the credit. A small employer is one that employs 100 employees or less and has not sponsored a qualified retirement plan during the three-(3) tax years preceding the first year for which the credit would apply. Consequently, the credit is a real incentive for small employers that have never sponsored a plan.

What costs qualify for the credit? Qualified startup costs are the ordinary and necessary expenses related to establishing and administering an eligible employer plan and the expenses associated with employee education.

What is an eligible employer plan? An eligible employer plan is any pension, profit sharing or 401(k) plan that includes an exempt trust, a simplified employee pension (SEP) or any SIMPLE plan.

Example: Employer is a small employer that establishes a 401(k) plan in November 2002 to be effective January 1, 2003. Employer incurs expenses associated with plan design, establishing the plan, payroll processing for employee elective deferrals and employee education regarding investment choices. Employer's expenses in 2002 are $2000. Employer elects to treat 2002 as the first credit year. Employer's credit in 2002 will be $500 (50% of 2000 but not in excess of $500). Employer will deduct $1500 ($2000 less the $500 credit) as an ordinary and necessary business expense.

A small employer that is considering a retirement plan next year should engage in some planning this year. Timely year end planning and preparation will not only facilitate payroll reduction and administration, but will also allow the small employer to apply the credit in the current tax year.

If you would like to discuss this topic in more detail, please call David M. Mosier at 814-459-2800 or e-mail: dmosier@kmgslaw.com.

For additional information contact David M. Mosier at 814-459-2800 or e-mail: dmosier@kmgslaw.com.